My entire portfolio management strategy revolves around the “Chowder Rule.”

The Chowder Rule is a little known, but highly effective stock screen designed to help generate reliable returns. It entails a few simple, yet often overlooked metrics to follow when buying or selling stocks.

I can’t take credit for coming up with this rule. The Chowder Rule was invented years ago by an investment blogger who goes by the handle “Chowder.” This rule, alongside his other contributions, has landed Chowder upon the Mount Rushmore of dividend investing.

The Chowder Rule is actually a set of guidelines based on what has become known as a “Chowder Number,” which is a company’s dividend yield in the present plus the company’s 5-year dividend growth rate.

The Chowder’s Ingredients

Here is the sub-set of criteria to the Chowder Rule:

• If a stock has a dividend yield greater than 3%, its 5-year dividend growth rate plus its dividend yield must be greater than 12%.
• If a stock has a dividend yield of less than 3%, its 5-year dividend growth rate plus its dividend yield must be greater than 15%.
• If a stock is a utility, its 5-year dividend growth rate plus its dividend yield must be greater than 8%.

Chowder’s goal when using these three rules is to generate annual returns of approximately 8%.

Right about now, you might be thinking to yourself, but wait…wouldn’t a 3% yield plus at least 9% dividend growth (which one can assume is in-line with earnings per share growth) result in 12% returns?

Well, yes. In a rational world, that would be true. However, Chowder is well aware of market volatility and the importance of giving one’s self a margin of safety when investing in equities. Therefore, he’s built that into his set of rules.

He’s given himself a 50% margin of safety (12% versus his target of 8%) with stocks that have dividend yields in the 3%+ range.

This margin of safety expands to 87.5% for the stocks with lower yields that require a Chowder Number of at least 15%. The logic behind this rule is the belief that growth companies will likely experience slowing growth over time as they mature and when this happens, share prices are likely to suffer due to multiple contraction.

Because of the regulated nature of utilities and their relatively reliable yields, the Chowder Rule doesn’t require an extra margin of safety for investments in that sector.

What I like so much about the components of the Chowder Rule is that while they’re built upon the foundation of dividend yield and dividend growth, valuation still lies at the heart of the matter.

Overvalued names often have lower dividend yields. The dividend growth component of the Chowder Number outweighs the importance of the dividend yield, but a lower yield could be the difference between passing the Rule screens or not.

And what’s more, I don’t even mind the over-reliance on the dividend growth figure because a 5-year dividend growth rate shows management’s effectiveness when it comes to producing the earnings and cash flows necessary to sustainably grow a dividend over time, as well as their generosity towards shareholders.

In reality, I don’t think it’s the Rule that matters so much as the Number itself. I pay close attention to the Chowder Number when making investments.

I do a lot of work when it comes to evaluation and dividend sustainability, so I don’t require such a wide margin of safety. I like to shoot for Chowder Numbers of at least 10 on all of my non-utility investments.

In a 2015 interview that I conducted with Chowder, he echoed this sentiment saying, “If others want to adjust the number to meet their objectives, that’s fine, as long as it supports what it is you are trying to do.”

In that interview, Chowder broke his rules down another way, further simplifying his philosophy, saying “This leads to a formula I adopted. I call it ‘The Success Formula That Never Fails.’ High Quality + High Current Yield + High Growth of Yield = High Total Return.”

It’s important to note that following these three simple criteria will not automatically result in 8% returns. There are no sure things in the equity market. Risk is always at hand.

Chowder himself thinks that his rules should be used last in the due diligence process. One of the downfalls of the Chowder Rule is the fact that they are based, in large part, on past performance. We’ve all heard it hundreds of times: past performance is no guarantee of future results.

However, I’d much rather focus on the proven returns of high-quality companies and their management teams than spend my time speculating on the unknowns that lie ahead in the future, especially when they’re macro concerns that don’t specifically relate to individual stocks in the market.

Jump aboard a rocket…

As I’ve just explained, it doesn’t make sense trying to time the market. You’re better served by investing in “rocket stocks.” Among the fastest rockets you can find are small-cap biotechnology stocks.

Biotech stocks can juice-up the gains in your portfolio. Pick the wrong biotech stock, though, and you could get slammed with sharp losses. The key is striking a balance between risk and reward and finding companies whose drugs in the pipeline are unique and in demand.

My colleague, Scott Chan, has found a biotech stock that meets all the right criteria. Scott is a lead analyst at Investing Daily’s Radical Wealth Alliance.

Scott’s research has uncovered a tiny, under-the-radar innovator with a new cancer-killing drug that’s on the fast track for FDA approval. This stock is poised to blast off, but you need to act now while shares are still cheap. Get the details by clicking here.