Wednesday, February 25, 2015

From Credit Analyst to Equity Analyst and Back Again

     When reading various dividend blogs, I'm always curious as to what their owners do as a day job. My personal observation is that many dividend bloggers are in the computer and engineering fields. These individuals use their ample technical, mathematical, and model building skills in order to analyze investments. I'm extremely lucky to work full-time as a credit analyst for a fantastic organization. At a high-level, I source, examine, and evaluate quantitative and qualitative data in order to determine a company's ability and willingness to pay their suppliers. Although I don't consider my technical skills particularly strong, nor have I ever bragged about my mathematical abilities, I think my day job helps me better analyze companies for potential investments.
     As a credit analyst, one of the most important functions I perform is a liquidity analysis on the business I'm analyzing. Even without complete financial information, it's essential to determine if a company generates sufficient cash to pay its suppliers. Over the short-term, a company may access debt or equity markets, sell assets, or increase their bank facilities in order to meet their obligations. In the long-term, cash is king, just as it is in dividend sustainability analysis. Ideally, I like to see businesses that generate sufficient free cash flow (which I would define as cash from operations less CAPEX and dividends) to not only pay their current obligations, but to reward their owners as well. Speaking as an owner of 26 quality companies, rising free cash flow makes me happy since I associate it with growing dividends in the future.
     The hardest aspect of my day job is assessing management's willingness to pay their suppliers. I've seen numerous cases of companies that had the funds to pay their suppliers, but instead chose to finance pet projects, make unsustainable payments to their owners, or ignore their contractual obligations. A company's payment history, including the course management takes when times are tough, is the best indicator of a company's willingness to pay their suppliers. Similarly, as a dividend investor, I like to look at a company's payment history to see how they treated their shareholders during the last valley in their business cycle. Did they continue to pay (and even hike) dividends? Or did they take the opportunity to cut the dividend and blame industry conditions for their lack of foresight?  Most business operate in cyclical industries, and knowing how management will perform and react when times get tough helps me to assess the safety of the current and future dividend payments.
     The great majority of my dividend growth holdings pass the grade of credit analysts, as evidenced by the number of investment grade companies I own in my portfolio. Of my nine US holdings, only Omega Healthcare Investors is below investment grade (and only by one notch at BB+). Similarly, of my 17 Canadian holdings, 13 of 14 are investment grade rated (Corus is one notch below at BB+) and three holdings don't have credit ratings.
     As a credit analyst and dividend growth investor, I feel my experiences in both my job and hobby helps me improve my process and results in the other.

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