If you only invest in quality companies that generate stable earnings or cash flows, you greatly reduce your chance of losing money.
What makes a quality company?
One facet of quality is a company has an investment-grade credit rating. Standard & Poor’s is one of the top three agencies that assigns credit ratings, which measure a firm’s ability to repay debt.
One way for companies to grow is by taking on debt to finance projects. So, a company’s ability to repay the debt it borrows is essential for the sustainability of the business.
S&P assigns the highest credit rating of AAA. An S&P credit rating of AAA means that a company is at very low risk of not repaying its debt. Credit ratings of A or above indicate high credit quality. And an investment-grade credit rating is BBB or higher.
For the past two decades, Toronto-Dominion Bank’s earnings per share (EPS) have been in a long-term-growth trend although there have been bumps along the road.
For example, between the fiscal years 2007 and 2009, its EPS declined nearly 29%. It was a harsh environment to operate in for any business because that period was during the financial crisis, which triggered a recession.
Yet Toronto-Dominion Bank was able to maintain its dividend per share (DPS) during that period. Since then the bank’s EPS have more than recovered to pre-crisis levels, and its DPS has increased 21% while maintaining a payout ratio below 50%.
Stable cash flows
For other companies, it makes more sense to look at their cash flow generation instead of their earnings. For example, in 2015 Enbridge Inc. (TSX:ENB)(NYSE:ENB) started using the financial metric of available cash flow from operation (ACFFO) to complement the financial metric of adjusted EPS.
The company believes the ACFFO gives greater insight into its ability to generate cash flow to drive shareholder value, including growing its dividend.
In 2015 Enbridge delivered a record $1.9 billion in adjusted earnings, which equated to $2.20 per share, and $3.2 billion in ACFFO, which equated to $3.72 per share and a payout ratio of 50%.
Enbridge has an S&P credit rating of BBB+ and has a 20-year dividend-growth streak. It also plans to grow its dividend by 10-12% per year through 2019. Its acquisition of Spectra Energy Corp. will help strengthen its position in North America and further solidify its growth.
By buying quality companies at decent valuations, investors can build their wealth slowly with a lower risk of losing money. Toronto-Dominion Bank and Enbridge are quality companies trading at fair valuations today. They should continue to generate stable earnings or cash flow growth into the future for long-term wealth generation.