The ultimate value investing checklist

This value investing checklist is for long-term value investors looking for a decent combination of income and growth.

It’s designed to help you find companies with the following characteristics:

• Quality
• A focused and market-leading core business which has existed for decades
  • Consistently high returns on capital employed
• Consistent and sustainable revenue, earnings and dividend growth
• Cautious management
• Durable competitive advantages
• Defensive
• Few debt and lease liabilities
• Stable, mature and defensive markets that are expected to continue growing for decades
  • Diversity across customers, suppliers and other key relationships
  • Little exposure to volatile commodity prices
• Value
• An attractive combination of dividend yield today plus potential dividend growth tomorrow

Of course, not every company has all of those features, so personally, I’m happy as long as a company combines an attractive valuation with at least one of the other two factors.

In other words:

• Low-quality cyclicals offering poor value are bad
• High-quality cyclicals and mediocre defensives offering good value are better
• High quality highly defensive companies offering good value are best

Here’s a brief summary of what you’ll find in this investment checklist:

• More than 30 questions covering competitive strength, valuation, balance sheet risk, capital intensity and much more.
• Almost 6,000 words in total, providing a detailed overview of my entire investment process.
• Rules of thumb outlining maximum or minimum limits for debts, acquisitions, return on capital and many other factors.

Table of Contents

• Housekeeping: Will this company be a good fit with your portfolio?
  • H.1. Will it increase your portfolio’s geographic diversity?
  • H.2. Will it increase your portfolio’s industrial diversity?
  • H.3. Are the shares liquid enough?
• Quality: Is this a quality company?
  • Q.1. Does it have a focused core business?
  • Q.2. Has it had the same core business for over a decade?
  • Q.3. Has it had broadly the same goal and strategy for over a decade?
  • Q.4. Has it earned consistently good returns?
  • Q.5. Has it produced consistent and sustainable growth?
  • Q.6. Is there a culture of evolution rather than transformation?
  • Q.7. Has management avoided excessively rapid expansion?
  • Q.8. Has management avoided excessive or low quality acquisitions?
  • Q.9. Does the company benefit from network effects?
  • Q.10. Does the company benefit from any unique assets?
  • Q.11. Is the company the market leader in its core market?
  • Q.12. Does the company benefit from switching costs?
• Defensive: Is this a defensive company?
  • D.1. Does the company have limited financial leverage?
  • D.2. Is the company’s core market defensive?
  • D.3. Is the core market expected to grow over the next ten years?
  • D.4. Is the core market relatively free from regulatory risk?
  • D.5. Is the core market unlikely to be disrupted?
  • D.6. Is the company free from significant concentration risk?
  • D.7. Is the company free from significant product or patent risk?
  • D.8. Is the company largely unaffected by commodity prices?
• Value: Is this company good value?
  • V.1. Is the company free from problems which are likely to materially reduce its long-term prospects?
  • V.2. Is the company likely to grow over the next 10 to 20 years (and if so, how fast)?
  • V.3. Do you think this investment is likely to outperform over the next five to ten years?
• Final Decision: Are you willing to invest in this company for many years?

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Housekeeping: Will this company be a good fit with your portfolio?

Before you dive into the enjoyable but lengthy task of analysing a company, it’s a good idea to check that the company will be a good fit with your existing portfolio.

For me, a good fit means two things: 1) Will it increase diversity and therefore help reduce risk and 2) will I be able to buy and sell as many shares as I like whenever I like?

H.1. Will it increase your portfolio’s geographic diversity?

Geographic risk is the risk that comes from investing in a given geographic area. So if all your holdings generate all their profits from the UK, then a UK recession would likely hit your portfolio hard.

This risk can be mitigated to a degree by investing in companies that operate in different countries and continents.

My rule of thumb is to keep UK revenues at less than 50% of my portfolio’s total revenues.

YES or NO – Explain your answer in detail.

H.2. Will it increase your portfolio’s industrial diversity?

Industry risk is the risk that comes from investing in a given industry. Many industries go through booms and busts, so investing in a wide range of industries will reduce your exposure to any one industry’s economic cycle.

My rule of thumb is to have no more than three out of about 30 holdings operating in any given industry. This keeps my portfolio’s direct exposure to each industry below 10%, or thereabouts.

You might also want to avoid investing in too many closely related industries.

YES or NO – Explain your answer in detail.

H.3. Are the shares liquid enough?

To buy or sell shares you need someone to trade with, and in most cases the stock exchange will do that for you. Even so, it can sometimes be hard to buy or sell a company’s shares because there’s nobody available to stand on the other side of the trade.

This is often the case with very small companies, where you may have to split up a trade into several smaller trades over several days. Personally I want to buy or sell as many shares as I need to in one single trade, so I usually only invest in larger companies and more liquid stocks. These are also easier to get out of in a hurry, if you need to.

One way to measure liquidity is the daily value of shares traded. So if Vodafone shares cost £1 each and 20 million shares are traded in a day, then the daily trading value was £20 million.

My rule of thumb is that a company’s daily trading value should be at least 100-times my typical trade size. So if, for example, I wanted to invest £1,000 in a company, then I’d want its daily trading value to be at least £100,000. 

In practice, if you stick to FTSE 100, FTSE 250 and FTSE Small-Cap companies (or their international equivalents) then you’re unlikely to run into liquidity problems unless your portfolio is very large.

YES or NO – Explain your answer in detail.

Quality: Is this a quality company?

Low quality companies tend to get killed off pretty quickly. Mediocre businesses may survive for a few business cycles, but they’re unlikely to produce much sustainable long-term growth and at some point the competition or the economy will kill them off too.

High quality companies, on the other hand, are far more likely to survive and thrive over multiple business cycles, decades and even centuries.

There are many definitions of a quality company, but a simple one is a company which can produce consistently high rates of return on capital across multiple business cycles. And in a reasonably free market economy, the only way to do that is if the company has durable competitive advantages.

Q.1. Does it have a focused core business?

Quality companies tend to be highly focused, doing a few things exceptionally well. 

A focused business is a niche business, which means niche customers, niche products or niche distribution channels. What a focused company doesn’t do is offer a broad range of products to a broad range of customers through a broad range of distribution channels.

This focus helps quality companies build more expertise, stronger brands, deeper relationships and greater market share than less focused competitors.

My rule of thumb is that a company’s core business should have a clearly defined niche (some combination of customers, products and distribution channels) and should generate at least two thirds of the company’s total revenues (i.e. twice as much as the rest of the company combined).

YES or NO – Explain your answer in detail.

Q.2. Has it had the same core business for over a decade?

Quality companies focus on the same customer/product/channel niches for a very long time. This prolonged focus is what allows them to build greater expertise, brands, relationships and scale than their less focused competitors.

All companies must evolve, but the best core businesses are usually the ones that have already been the core business for many years.

My rule of thumb is that today’s core business should have been the company’s core business at least ten years ago and preferably more than 20.

YES or NO – Explain your answer in detail.

Q.3. Has it had broadly the same goal and strategy for over a decade?

Quality companies are usually focused on long-term success, following broadly the same long-term strategy in pursuit of broadly the same long-term goal for years, decades and in some cases, centuries.

What they don’t do is repeatedly switch goals or strategies at the first sign of trouble.

My rule of thumb is that a company should have pursued more or less the same long-term goal using more or less the same strategy for at least ten years.

YES or NO – Explain your answer in detail.

Q.4. Has it earned consistently good returns?

Quality companies produce consistently high returns on capital thanks to their durable competitive advantages.

Low and mediocre quality companies produce low and mediocre returns on capital because they lack durable competitive advantages. If they could produce higher returns then they would, but they can’t. At least not sustainably over any meaningful (i.e. multi-year) period of time.

My rule of thumb is that net return on capital (i.e. after-tax return on equity capital, debt capital and leased capital) should average at least 10% over the last ten years, which is comfortably above the FTSE All-Share average.

As well as being a sign of quality, consistently high returns on capital can help companies grow organically by reinvesting retained earnings, rather than fuelling growth with debt or leased assets.

Another indicator of quality is healthy profit margins, otherwise known as return on sales. This can be very industry specific, but generally I look for profit margins that have been consistently above 5% over the last ten years.

YES or NO – Explain your answer in detail.

Q.5. Has it produced consistent and sustainable growth?

Quality companies use their consistently high returns on capital to fuel consistent and sustainable growth over many decades. Quality companies which operate in cyclical sectors may see declines during cyclical downturns, but they still produce consistent growth from one cycle to the next. 

By consistent and sustainable growth I mean:

1. Per share capital employed, revenue and dividend growth ahead of inflation over ten years (Growth Rate).
2. Consistent and sustainable growth of capital employed, revenues, earnings and dividends per share over ten years (Growth Quality).

My rules of thumb for consistent growth (using metrics from my Company Review Spreadsheet) are:

Growth Rate: Should be above 2% per year (i.e. the Bank of England inflation target) for revenues, capital employed and dividends per share.

Growth Quality: Should be above 75%. There should also be no prolonged periods of revenue or earnings decline (e.g. more than four years in a row).

YES or NO – Explain your answer in detail.

Q.6. Is there a culture of evolution rather than transformation?

Quality companies tend to prefer evolution over transformation.

Here’s one definition of business transformation:

“the process of fundamentally changing the systems, processes, people and technology across a whole business or business unit, to achieve measurable improvements in efficiency, effectiveness and stakeholder satisfaction.”

Evolution is cautious, incremental and builds sustainably on existing competencies. Transformation is risky, disruptive and can be a sign that management lacks foresight.

Sometimes business transformation is necessary because an industry changes in a way which is both rapid and unexpected. In most cases though, risky transformation projects can be avoided by continuously evolving a company towards where it needs to be a decade from now.

My rule of thumb is that a company should not have undertaken any large scale transformation projects within the last ten years, unless they were low risk and well-executed.

YES or NO – Explain your answer in detail.

Q.7. Has management avoided excessively rapid expansion?

Quality companies are interested in long-term sustainable growth rather than short-term rapid growth, especially if rapid growth puts the whole organisation at risk.

Excessively rapid growth means a rapid increase in stores, factories, machinery and other systems, and lots of new employees. This combines inexperience with rapid change, and the result can be teething problems which take management attention away from the core cash cow business.

If rapid growth is rampant across an industry (such as the supermarket ‘space race’ of the 80s and 90s or the US fracking boom of the 2000s) it can produce an excess of supply (e.g. too many supermarkets or too much oil & gas). That excess can push down prices, devastating returns on all that newly invested capital.

I have two rules of thumb for high growth companies:

1) For capital intensive companies (where average capex is greater than average earnings), total capex over the last ten years should not exceed 200% of total depreciation over the period. Aggressive capex on this scale can be disruptive to normal operations, it creates oversupply risk and it can have very negative effects on cash flow (cash flow will be weak relative to earnings, which may put the dividend at risk).

2) Additional external funding (from debts and leases) taken on over the last ten years to fuel growth should not exceed 50% of total earnings over the same period. This tends to be more common among high growth, low quality businesses as they don’t generate enough cash to fuel rapid growth, so they borrow money and lease assets instead.

YES or NO – Explain your answer in detail.

Q.8. Has management avoided excessive or low quality acquisitions?

Quality companies prefer low risk organic growth fuelled by retained earnings rather than high risk inorganic growth driven by large debt or equity fuelled acquisitions.

Acquisitions are entirely reasonable, but integrating excessive acquisitions (in size or number) can be distracting for management and disruptive to the existing core business.

My rule of thumb is that the total amount spent on acquisitions over the last ten years should not exceed the total amount earned by the acquirer over that period. I may make an exception if the acquisitions operate as separate companies (therefore producing few integration headaches) or if the acquisitions were almost ten years ago and have since been completely integrated.

The quality of acquisitions also matters. Good acquisitions tend to have the following characteristics: 1) they are closely related to the acquirer’s core business, 2) they are a quality business in their own right and 3) the company is acquired at an attractive price.

My rule of thumb is to avoid companies that have a history of acquiring mediocre competitors or companies operating in unrelated markets.

YES or NO – Explain your answer in detail.

Q.9. Does the company benefit from network effects?

Quality companies consistently produce above average returns on capital because they have durable competitive advantages. These advantages make their products or services either better, cheaper to produce or more convenient than the alternatives.

There are four main competitive advantages which I like to focus on. In order of preference these are: 1) network effects, 2) unique assets, 3) market leadership, 4) switching costs.

Network effects occur when the number of customers or users is an essential element in how good the product or service is.

For example, English is the most widely spoken language in the world, and in a world that becomes ever-more connected it makes sense for ever-more non-English speakers to speak English. This creates more English speakers which only makes the language more attractive.

Network effects often lead to de-facto standards (such as clock faces or keyboard layouts) and frequently produce “winner takes all” economics, where the market leader dominates. Even worse for competitors, dominant network effects are virtually impossible to break or replicate. However, there is also a real risk of government intervention to break up or nationalise these natural monopolies.

Social media platforms are good examples, such as Facebook, Twitter or LinkedIn. Market platforms are also good examples and include Rightmove and eBay.

YES or NO – Explain your answer in detail.

Q.10. Does the company benefit from any unique assets?

Unique assets can be a durable competitive advantage. They need to be cheap to maintain, expensive or impossible to replicate, and they need to make the company’s products or services either better, cheaper to produce or more convenient than the competition.

Potentially valuable and hard to replicate unique assets include brand names (especially ones that are more trusted or desirable than the competition), patents (although these have a limited lifespan) and locations (that are typically either cheaper for accessing raw materials, more efficient for distribution or more convenient for customers).

A company’s culture can also be a valuable, hard to replicate and cheap to maintain unique asset. This can be hard to assess, but there are recurring signs such as ongoing founder (or founding family) ownership and involvement, long serving employees and a history of long tenure CEOs who worked in the company for many years before becoming CEO.

YES or NO – Explain your answer in detail.

Q.11. Is the company the market leader in its core market?

Market leadership brings many advantages such as greater brand awareness, more negotiating power with suppliers, more efficient production, more ability to attract talented employees, more experience, more data and more influence with regulators. Another key advantage is trust. Most people implicitly trust the market leader (or the perceived market leader), which is summed up nicely by the phrase, “nobody ever got fired for buying IBM”.

If the market leader doesn’t make any serious mistakes then it can be very hard for followers to overtake the leader.

YES or NO – Explain your answer in detail.

Q.12. Does the company benefit from switching costs?

Switching costs exist when it takes a meaningful amount of time, effort or money to switch from one company’s products or services to another. 

Common examples are utility suppliers (gas, electricity, internet, phone, etc), computer operating systems (it’s much easier to stay with Windows, Apple or Android than it is to switch between them), enterprise software (where staff are used to using the current system, have entered large volumes of data into it and have integrated it with other software systems) or social media platforms (where you’ve made lots of ‘friends’ and uploaded lots of photos).

In contrast, most people can switch from one car manufacturer, toothpaste brand or supermarket to another with little or no effort.

Switching costs are the least attractive competitive strength because they’re easy to replicate and they only block customers from leaving rather than attracting them in the first place. For switching costs to be effective the company still needs a way to attract customers other than just lowering prices (unless the company is the lowest cost supplier in the market). 

YES or NO – Explain your answer in detail.

Defensive: Is this a defensive company?

As a long-term investor I may own a company’s shares for five, ten or even twenty years. Over that sort of timeframe, many bad things can happen to the economy.

Investing in quality companies is one way to defend against an uncertain and hostile future. Another is to invest in companies which are relatively defensive. Even better is to have both attributes in the same company.

For me, a defensive company is a low risk company. There are innumerable factors that create risk for companies, so the following questions cover just a few of the most important ones.

D.1. Does the company have limited financial leverage?

Truly defensive companies are relatively stable in choppy economic waters, and that means they don’t use much debt in the form of either borrowings or leases. 

Debt is called leverage because it amplifies the performance of a company, for better or worse. 

For example, if a company borrows £1 million to buy a factory, it might then have to make a fixed 5% (£50,000) annual interest payment. 

If the factory earns £100,000 before interest and tax (EBIT) then it will have £50,000 of earnings left after interest but before tax (EBT). If EBIT goes up by 50% to £150,000 then EBT will go up by 100% to £100,000. 

As you can see, debt leverage has amplified the increase in earnings, from a 50% increase before interest to a 100% increase after interest.

That sounds good, but the same applies in reverse. If EBIT declined by 50% from £100,000 to £50,000, then EBT would decline from £50,000 to zero, a 100% decrease.

This is why some highly leveraged companies operating in traditionally defensive markets are in practice cyclical rather than defensive. They have so much debt that their stable revenues are turned into volatile earnings thanks to dangerously high fixed costs from debt interest and rental payments.

On the other hand, a company operating in a cyclical sector can produce results more akin to a traditionally defensive company by using next to no leverage from debts or leases.

My rule of thumb for debts and leases is that they should be below average, where average depends on whether the company’s sector is cyclical or defensive.

For cyclical sector companies, a ratio of debt plus leases to ten-year average earnings (which I call the Debt Ratio) of 4.0 is about average.

For defensive sector companies, a Debt Ratio of 5.0 is about average.

Lower is better, and companies operating in highly cyclical sectors (oil and gas, mining, construction) should have a Debt Ratio of 3.0 or less.

There are additional rules for banks and insurers which I don’t have the space to go into here. You can see these rules in the Company Review Spreadsheet.

YES or NO – Explain your answer in detail.

D.2. Is the company’s core market defensive?

Defensive companies usually operate in defensive markets, i.e. markets where prices or demand don’t go down much during normal economic cycles. 

One way to think about the defensiveness of a market is to ask how bad the economy would have to be before customers stopped buying the product or service. 

For example, if the economy takes a turn for the worse, it’s very easy for most people to not buy a house or a car. You just keep using the one you already have. So markets for products or services which are durable and expensive are usually very cyclical.

On the other hand, how bad would the economy have to be for you to stop buying toilet paper or toothpaste? It would basically have to be armageddon. So markets for products which are non-durable, used daily and cheap are usually very defensive.

Cyclical businesses are not necessarily bad, but they do need to have stronger balance sheets to protect them through the inevitable cyclical downturns.

YES or NO – Explain your answer in detail.

D.3. Is the core market expected to grow over the next ten years?

Defensive companies operate in markets that are likely to grow, or at the very least maintain their size in line with inflation. 

A market which is in terminal decline should not be described as defensive, even if demand is fairly consistent across most economic conditions.

For example, the worldwide market for tobacco products is very non-cyclical, but it’s in long-term decline so it isn’t really defensive. 

YES or NO – Explain your answer in detail.

D.4. Is the core market relatively free from regulatory risk?

Defensive companies are low risk, and one significant risk for many companies is the risk of large and unexpected regulatory change.

Abrupt regulatory change can damage the value of even the highest quality company. That’s why it’s a good idea to think about the regulatory risks that exist in a company’s core market. 

A good question to ask is: does this company provide more value to its customers than it receives in payment? If you don’t think the company is adding value to the world then how would the company be affected if consumer protection regulations were tightened up? Possible examples are tobacco, gambling and pay-day lending companies, and even fizzy drinks companies have been hit recently with a new levy on sugary drinks.

YES or NO – Explain your answer in detail.

D.5. Is the core market unlikely to be disrupted?

Defensive companies operate in markets that are unlikely to change dramatically over at least the next ten years, and preferably much longer than that.

Dramatic change increases uncertainty and risk, so markets that are likely to change dramatically over the next ten or twenty years cannot be called defensive.

The newspaper industry is a good example. It was once very defensive but has now been massively disrupted by technology, so I would no longer call the paper newspaper business defensive. 

Newspapers are an obvious example, but as we work our way through the fourth industrial revolution (driven by rapid growth in computing power, Internet connected people and things, machine learning, advanced materials and more), sector after sector is being hit by disruption. 

The future will always be uncertain, but it’s still worth thinking about what disruptive forces could be unleashed on a company’s core market within the next decade. In some cases the market will already be going through a period of disruption, while in other cases you may have to stretch your imagination out ten or 20 years into the future. But the exercise should be worth it.

An example of near-term disruption is the impact of online shopping on high street retailers. An example of far-term disruption is the impact of autonomous vehicles on car manufacturers and dealers.

This also ties into the long-term focus of high quality businesses. They tend to spot these disruptive changes early, giving them time to evolve so they can thrive in the new reality.

YES or NO – Explain your answer in detail.

D.6. Is the company free from significant concentration risk?

Defensive companies don’t put all their eggs in one basket. More specifically, they don’t put too much of their destiny in the hands of one customer, one supplier, one contract or one star employee.

Customer risk: Companies lose customers all the time. This isn’t a problem if the company has a diverse customer base, but if a significant portion of profits come from one customer then losing that customer can have a seriously negative and permanent impact. A similar risk exists with suppliers, especially if the supply agreement takes a long time to put together.

Contract risk: Some companies rely on very large contracts, such as rail franchises or  construction contracts. There are many problems with large contracts.

For example, large contracts are often worth millions of pounds over many years. Due to the sums involved, clients do due diligence and take bids from multiple suppliers. The end result is a highly competitive bidding process where suppliers are unlikely to earn fat profit margins. 

Also, some suppliers will have staff sitting around doing nothing if they fail to win a contract. In that case it can make economic sense to take on a contract even if it is certain to be loss making, as long as the loss is less than the loss that would be incurred by losing key staff and potentially losing the ability to fulfil future more profitable contracts. This is called suicide bidding. 

Suicide bidding can be a serious drag on margins across whole sectors. One example is government outsourcing, where outsourced service providers go bust or come close to it with depressing regularity. Fortunately the government has begun to address its historic tendency to award contracts to the lowest bidder, rather than the best value for money bidder.

My rule of thumb is that a company shouldn’t have more than 10% of its revenues or profits coming from one customer, including the government. No single contract should make up more than 10% of revenues or profits, and no single supplier or employee (e.g. fund manager) should supply the goods or services which generate 10% of the company’s revenues or profits (unless they can be replaced almost immediately, such as an electricity supplier).

YES or NO – Explain your answer in detail.

D.7. Is the company free from significant product or patent risk?

Defensive companies provide goods and services which do not need to change frequently and which are supported by immortal intellectual property (e.g. trade marks) rather than temporary intellectual property (e.g. patents).

Examples of products which change infrequently and are protected by trade marks are Coca Cola, Dove soap and Wrigley’s chewing gum. 

Other products, often technology products, need to be replaced with a completely new version every few years to keep ahead of or even just up with the competition. There is a risk that the replacement will not be as successful. 

The size of this risk depends on the amount of reinvention required. So minor updates (like a new model of smartphone or a facelifted Toyota) are low risk, while designing a new product aimed at a new market to offset commoditisation in an old market is high risk.

Similar risks exist with large patents (such as those in the pharmaceutical industry) which typically expire within 20 years. This leaves profit margins exposed to generic competition unless a powerful brand name has been built up during the patent’s lifetime (such as Nurofen).

My rule of thumb is that at least 80% of a company’s revenues and profits should be generated by products or services which don’t change very much and which are protected by eternal intellectual property such as trade marks rather than patents.

YES or NO – Explain your answer in detail.

D.8. Is the company largely unaffected by commodity prices?

Defensive companies tend to have more stable revenues and earnings than other companies, so they’re unlikely to have much exposure to the inherently volatile prices of commodities like oil and gas.

I will sometimes invest in companies with significant commodity price exposure (such as companies operating in the oil and gas or mining sectors) but the company must be a very high quality business, with a long track record of success, high rates of return on capital, low or no debt and cautious management.

YES or NO – Explain your answer in detail.

Value: Is this company good value?

Even if you find the highest quality and most defensive company in the market, it won’t produce a satisfactory combination of income and growth if you pay too much for its shares. So all sensible investors are value investors to some extent, even if they call themselves something else.

For me, a satisfactory return is where both dividend income and capital growth exceed those of the FTSE All-Share. Failing that, I’d like the total return from income and growth to beat the FTSE All-Share, and a total annualised return north of 10% would be ideal.

To achieve that I invest in a diverse group of companies that are either high quality, defensive or both, and I invest in them when their dividend yields and expected total returns are attractive.

Having invested, these companies then need to grow their revenues, earnings and dividends at a certain pace to at least keep up with inflation and drive capital gains.

So in trying to decide whether a company’s shares are good value or not, I like to think about:

a) current events or short-term risks which could stop the company from having a prosperous future, 

b) whether the company is likely to have a prosperous future once current risks (if there are any) are overcome, and 

c) whether the combination of dividend yield and potential dividend growth seem attractive.

V.1. Is the company free from problems which are likely to materially reduce its long-term prospects?

Successful value investments are purchased at a price which is below fair value, and that often occurs when a company is out of favour because it has obvious problems.

However, obvious problems are not necessarily serious problems. If a company does have obvious problems then it’s important to think about whether they’re a minor bump in the road or likely to cause serious long-term damage.

Ideally I’m looking for companies suffering from obvious but ultimately trivial problems which are nonetheless keeping buyers away and depressing the share price.

YES or NO – Explain your answer in detail.

V.2. Is the company likely to grow over the next 10 to 20 years (and if so, how fast)?

Growth is a key component of value and my preferred method of estimating future return is to combine dividend yield with an estimate of likely dividend growth (the yield can either be the actual yield or the expected “normal” yield if the dividend is temporarily reduced, perhaps due to a recession or pandemic).

My ideal rate of return is at least 10% per year, so if a company is likely to grow at 2% per year for the next 20 years, then I would usually only want to buy if the dividend yield was 8% or better. And if the estimated 20-year growth rate was nearer 8%, then I might be willing to buy when the dividend yield was only 2%.

It might seem somewhat excessive to think about growth over 20 years, and of course it’s subject to a lot of uncertainty, but there is some logic behind such a long-term view.

As a long-term investor, I could easily end up holding a company for ten years. If I buy a company today at 100p per share and with a dividend of 3p, it has a yield of 3%. If that dividend grows at 7% per year then that’s a pretty good return from dividends. But what about the share price? 

If the 3p dividend grows at 7% then it will have more or less doubled to 6p over those ten years. If investors think the company can only grow by 4% per year over the subsequent decade then they might demand a dividend yield of 6% (to give then an expected yield-plus-growth return of 10%).

So the company has a 3p dividend today and a 6p dividend ten years from now. If investors demand a 6% yield in ten years then they’ll be willing to pay 100p per share, leaving the share price exactly where it was ten years before!

Zero capital gain is not a brilliant outcome from an investment where the dividend grew by 7% per year for ten years. So if you’re a long-term investor, long-term growth prospects matter just as much as the starting valuation and dividend yield.

YES or NO – Explain your answer in detail.

V.3. Do you think this investment is likely to outperform over the next five to ten years?

As I’ve just mentioned, even a high quality super defensive company can turn into a bad investment if the purchase price was too high. 

What seems like a high or low price will depend on the specifics of each company, but to a large extent it will depend on the company’s likely future growth rate and the amount of uncertainty around its future growth.

For example, it might be reasonable to accept a 3% dividend yield from a high quality highly defensive company growing at 8% per year. But you might demand a 6% dividend yield from a lower quality cyclical company which has grown at the same 8% rate over the last decade. A higher yield is required from the cyclical company to make up for the increased uncertainty.

My rule of thumb is that the dividend yield plus a reasonable estimate of dividend growth should exceed the yield plus growth estimate for the FTSE All-Share (or your chosen index). And personally I look for a yield plus growth estimate of 10% or more, although I don’t always find it.

Another rule of thumb is that the PE10 and PD10 ratios (price to ten-year average earnings and dividends) should be below 30 and 60 respectively, and perhaps below 20 and 40 respectively for cyclical companies.

For highly cyclical companies (oil and gas, mining, construction) there’s a significant risk that their business cyclical will temporarily produce high growth rates which could lead some investors to overpay for their shares at the peak of the cycle. To avoid this mistake, I think PE10 and PD10 should be below 10 and 20 respectively for highly cyclical companies. This stricter rule should limit the purchase of highly cyclical companies to periods when their markets and share prices are near cyclical lows, and where future returns are therefore near cyclical highs.

YES or NO – Explain your answer in detail.

Final Decision: Are you willing to invest in this company for many years?

As a final sanity check, here are the big four questions again:

1. Is this company a good fit with your portfolio?
2. Is this a quality company?
3. Is this a defensive company?
4. Is this company good value?

And a few final thoughts:

• Low quality cyclical companies offering poor value are bad
• High quality cyclicals and highly defensives offering good value are better
• High quality defensive companies offering good value are best

YES or NO – Summarise the entire review into a few key points.