Wednesday, January 21, 2015

Rising Earnings – The Source of Future Dividend Growth

Successful dividend investors understand that a steadily rising dividend payment only tells half of the story. Most dividend paying companies that have been able to consistently raise distributions for at least one decade have enjoyed a steady pattern of earnings during that period of time.

As a dividend growth investor, my goal is to find attractively valued stocks that consistently grow their dividends. I run screens on the list of dividend champions and contenders using my secret entry criteria, and then look at the list company by company. Not surprisingly, I look for a record of increasing dividends. But I look for much more than that in a company.

In a previous article I discussed the three stages that dividend growth companies generally exist in. My goal is to focus on those in the second stage, although I might occasionally select a company from the first phase. However, I try to buy not just companies that have a record of raising dividends, but those that have decent odds of continuing that streak for the next 20 – 30 years. Not every company will achieve that, but for those that do, they would generate the bulk of portfolio dividend growth. The hidden source of dividend growth potential is expected earnings growth.

As you can tell from looking at my stock analysis reports, I look for companies that can increase earnings per share over time. Rising earnings per share can essentially provide the fuel behind future dividend growth. For example, Colgate-Palmolive (CL) has increased dividends for 51 years in a row. Over the past decade, it has managed to increase EPS from $1.17 in 2004 to an estimated $2.93/share for 2014. This has allowed the company to increase annual dividends from $0.48/share in 2004 to $1.42/share. The rest has been invested back into the business, to fuel potential for more earnings growth.

A company that is unable to grow earnings over time can only afford to grow dividends for so long. For example, Diebold (DBD) has managed to increase dividends for 60 years in a row through 2013, and had a very current yield. Unfortunately, the company has been unable to grow earnings as of lately, and the dividend payout ratio is reaching the limits of what a sustainable distribution could be. As a result, the stock has kept dividends flat in 2014, and as a result its streak of dividend growth is over. Therefore, the list of dividend kings will shrink for the first time since I have been tracking it.

Just as with dividend growth, I take past records of earnings growth with a grain of salt. You want to think about catalysts that would help propel earnings higher. For example, in the case of Colgate-Palmolive, the company has strong branded and relatively inexpensive products that consumers buy on a frequent basis. Most of these purchases are repeat business for Colgate – Palmolive, and consumers tend to stick to the brand of say toothpaste they have been using for years. Most consumers will stick to a brand whose quality they trust, and might not even notice a slight increase in prices over time. If you like Colgate toothpaste, and you care for your teeth, you would not substitute it for a generic brand that might be 50 cents cheaper. With this pricing power, Colgate can effectively manage to pass on costs to consumers. This could result in rising profits over time.

You can see that the qualitative analysis is important. If a company has strong brands, and competitive advantages, it can afford to increase prices, and that would not affect profits generated from loyal customers. This can generate profits to fuel dividends for years to come. For example, US companies such as Altria Group (MO) sell an addictive product, whose prices have been increasing for years. Despite the decrease in number of users over time, the increases in prices and constant looking for efficiencies has led to rising profits for decades. This stream of rising profits has fueled the dividend growth behind Altria, which has managed to reward shareholders with higher payouts for over 45 years in a row, adjusting for spin-offs of Kraft and Phillip Morris International (PM).

What you want to avoid is companies that offer commodity type products, companies that could lose leadership positions due to technological change as well as companies that are cyclical in nature. A commodity company is usually a price taker, not a price setter, and therefore does not have the pricing power of a Coca-Cola (KO) or Colgate – Palmolive for example. This can lead to erratic earnings, as prices would fluctuate depending on economic conditions for example. As a result, very few steel companies have managed to maintain an unbroken record of rising dividend payments. The only exception seem to be oil companies, some of which have been able to reward shareholders with rising payouts for over 25 years. This could be due to the nature of oil and natural gas, which once used, cannot be re-used, unlike other commodities such as steel and gold.

You also want to avoid companies which have gotten temporarily lucky. A prime example include some gold companies, which have records of raising distributions for one decade. Unfortunately, this coincides with the boom in gold and silver prices since the bottom in 1999. Even worse, many of these companies have pretty low payouts, which might make it easy to become a dividend achiever, but the paltry yields would be a turn off for investors.

Last, but not least, companies whose products or services could be deemed obsolete by shifts in technology, will not be able to earn sufficient profits to maintain a growing stream of dividend payments. Technology companies seldom have the durable competitive advantages that would make them holds for 15- 20 years. I cannot predict whether Intel (INTC) would still be in a competitive position in 2028 – 2033, or its products would be obsolete. However, I can pretty reasonably expect that people would still eat their favorite potato chips made by PepsiCo (PEP) or drink their favorite Coke or another one of the 500 drinks that the Coca-Cola Company (KO) makes.

In summary, a company that manages to grow earnings over time, should be able to afford to reward shareholders with a growing dividend income stream. Investors should analyze each company in detail, and determine if it has the qualitative characteristics that would allow it to grow earnings. If those characteristics are met, then the job of the investor is to acquire such securities at reasonable valuations as part of their diversified portfolio.

Full Disclosure: Long CL, PEP, KO, CL, MO, KRFT, PM, MDLZ

Relevant Articles:

How to read my stock analysis reports
Seven wide-moat dividends stocks to consider
Strong Brands Grow Dividends
Dividend Growth Stocks are Compounding Machines
Let dividends do the heavy lifting for your retirement

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