Wednesday, August 21, 2013

The predictive value of rising dividends

Newton’s first law states that a body in motion at a constant velocity will remain in motion in a straight line unless acted upon by an outside force. While Newton lost a lot of money during the South Sea bubble in 1720 chasing hot stocks, he could have made a lot more simply by applying his findings to the world of investing in dividend stocks instead.

In my years of investing in dividend stocks, I have noticed that companies which consistently raise dividends every year tend to keep raising dividends going forward. Companies which sporadically boost dividends for short periods of time, only to freeze or cut them later tend to repeat this activity over and over throughout their corporate histories. Unfortunately, many dividend investors fail to learn from history. As a result, these investors hope for the best when dividends are kept unchanged or cut, and predict dividend cuts as the distribution is raised to record levels for many years.

The companies which tend to consistently raise dividends tend to have business models that deliver the type of sustainable earnings growth that supports dividend growth. These companies manage to expand their businesses by creating a plan and sticking to it, while capitalizing on long-term economic trends and keeping their business vibrant and innovative. In addition, many companies that have managed to achieve long streaks of dividend increases are owners of strong global brands, have strong competitive advantages and are able to deliver value added products or services, which are characterized by high quality. As a result, it would be very difficult for a competitor to steal away customers based on price alone. In order to steal customers away, a competitor would have to spend years losing money, before carving out a profitable niche in the industry. The high returns on equity result in businesses that generate so much in free cash flow, that they have to return some to shareholders. The high return on equity also translates into lower capital requirements to stay relevant or expand the business over time.

For example, Wal-Mart Stores (WMT) is known for its low prices. If another retailer tries to steal customers away, they would have to beat the efficient distribution network, scale and long-term relationships/deals that Wal-Mart has with suppliers. In addition, because Wal-Mart has so many locations, it can afford lose money in a given market in order to eliminate competition there.

Another example includes Colgate-Palmolive (CL) toothpaste. Customers who purchase this product do so in a repeatable manner, because they like the quality of the toothpaste. People’s teeth are important to them, which is why they would likely keep on purchasing the same brand of toothpaste even if prices were going up, rather than save money and purchase a cheaper product. That is especially true if the quality of the cheaper product is not perceived to be as high. In order to increase consumer awareness, marketers for the cheaper toothpaste would have to spend large sums of money convincing customers of the positive effects of their products. The cheaper toothpaste company would keep losing money for long periods of time, because people’s tastes do not change overnight. A company like Colgate-Palmolive (CL) would maintain its competitive position if it innovates constantly and betters its products, and mint cash along the way to distribute to shareholders.

The repeatable nature of the transactions for companies like Wal-Mart and Colgate-Palmolive is occurring millions of times every week. Because they are providing products to use in peoples every day’s lives, many such companies are able to predict how much they are going to sell within a few percentage points. As a result, the Boards of Directors are able to predict with a reasonable amount of certainty the amount of funds the company would be able to sustainably allocate in order to pay dividends over the next year. In addition, many companies in the US pride themselves on their long records of dividend payments or dividend increases. The dividend is typically seen as a “sacred cow”, and would only be cut or eliminated under dire circumstances. In addition, companies like Coca-Cola (KO) and Johnson & Johnson (JNJ) which have the culture of consistently boosting distributions, would continue doing so, as long as the business fundamentals support this move. Even short-term weaknesses in earnings would not lead to elimination of the dividend growth culture in such companies. A dividend freeze or a dividend cut however would probably mean that the wheels of fortune are turning at these companies. As a result, these companies would likely avoid taking such actions, unless absolutely necessary.

Full disclosure: Long  WMT, CL, JNJ, KO

Relevant Articles:

Ten Dividend Stocks with High Returns on Equity
Dividend Stocks for the next decade and beyond
Strong Brands Grow Dividends
Seven wide-moat dividends stocks to consider
Avoid Dividend Cutters at All Costs

1 comment:

  1. Good article and I have been considering what you have said. I may be changing my entry criteria and not not look at contenders anymore. To young of a track record.
    DFG

    ReplyDelete

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