Friday, September 25, 2015

Does Market Capitalization Matter in dividend investing?

One criticism of Dividend Growth Investing is that it focuses exclusively on large cap stocks. The common complaint is that if you buy a small cap today, it can grow out to be as big as Johnson & Johnson (JNJ), Coca-Cola (KO), Exxon-Mobil (XOM), or Wal-Mart (WMT) etc.

In theory this sounds like a great idea. The problem of course is that this complaint completely ignores reality and facts. The reality is that when each of the companies I mentioned above became dividend achievers ( meaning that they had regularly increased dividends for at least ten consecutive years in a row), they were big companies already. Yet somehow, they managed to grow earnings and dividends for decades. This is the beauty of a stable company which has a successful business model that showers shareholders with cash each year.

In reality, if you were able to buy each of those companies when they just became dividend achievers, you would have banked a boatload of dividends. Plus, there would have been a pretty sizeable growth in share prices over time.

I looked at each company at the time they became dividend achievers. I calculated the returns as of September 21, 2015, assuming that someone put $100 at the end of the year in which they achieved that status. Check the table below. It is interesting that those companies that were already deemed as large-caps at the time delivered phenomenal  results to investors. For example, a $100 investment in Exxon at the end of 1992, with dividends reinvested, would have turned to $891.73. That investment would be generating $35.48 in annual dividend income. This means that the investor of 2015 will be getting their original investment in cash every three years.

Yrs Raising Dividends
Div Achiever Status
$100 turns to
Annual Income
 $      891.73
 $          35.48
 $   8,519.56
 $        286.96
 $   8,623.14
 $        277.78
 $   7,409.30
 $        227.90

In reality, I have trouble when people criticize one aspect of an investing philosophy, but fail to see the big picture, and how the strategy operates. It is also troubling when someone tries to fit the world to their beliefs by only looking for large or mid or small caps, and not simply focusing on opportunities.

I do not focus on market capitalization when I search for companies to buy. I actually focus on companies that have grown dividends for at least 10 years. Then I analyze those companies, look at quantitative and qualitative factors, before deciding whether there is a chance for future earnings growth. Only after that, do I focus on valuation, and try to purchase the stock if it is fairly valued and cheaper relative to other opportunities available to me. Whether a company has a market cap of $100 billion or $100 million is irrelevant, as long as it can satisfy my modest requirements. There is reasoning behind each and every one of these criterion mentioned in this paragraph.

For example, ten year requirement vets out most companies which were able to raise dividends merely because they caught a short-term economic tailwind. I am also ignoring companies which managed to boost dividends merely because they expanded their payout ratio from say 5% to 30%. Since the economic cycle averages five years, I am effectively ignoring companies that managed to get lucky in one cycle, but continued raising dividends in the next cycle, because dividend payout ratios were low to begin with. I repeat the thinking behind the other criterion so often on my site, that I won’t bore you with details for the 100th time.

I do not try to fit my entry criteria into molds that other people impose on me, without really thinking through why these are important in the first place.

Large companies have the scale to prevent competitors from entering their turfs and eating their lunch. I have very little confidence that an upstart beverage company can compete with the scale of Coca-Cola (KO), PepsiCo (PEP) or Nestle (NSRGY).

In addition, in my study of companies I own, I have uncovered some very counterintuitive findings.
Most large cap companies like Johnson & Johnson (JNJ), and Coca-Cola (KO), were large cap companies when they first became dividend achievers. They have the advantages of scale, know-how, and expertise of how to get their efficient systems to work in different environments.

I also like to study retail and restaurant companies. From a probability standpoint, it is more likely for a retail or restaurant chain with 1000 locations to double over time, albeit slowly, rather than for an unproven concept with 5 locations in one area to double or triple operations. The risks for the smaller company are unknown location, lack of skills and experience, and not knowing whether success is merely a byproduct of the original location and how replicable the concept really is. On the other hand, a company with 1000 locations already has an established user base, has experience how to replicate model in different conditions and situations, and has the advantages of scale and ease of access to capital. If you are going to be buying cheese or bread, your per unit costs are going to be lower when you buy for 1000 restaurants than when you buy for 5 of them. This is basic economics. While the chain with 5 locations could deliver astronomical returns, there is a higher chance of failure, which reduces the expected value of the investment.

Most investors ignore large cap companies, because they view them as slow growing, which is one reason why their valuations are usually much cheaper relative to hot growth companies. When investors see small growth companies, they get super excited about the possibilities for future growth, which is why they bid up those shares to stratospheric valuations. The goal of the investing game is not only to figure out the company that will increase the size of revenues and profit for the next 30 years, but also to buy it at attractive valuations, which would ensure a decent return on investment.

And no, buying shares in companies at 20 times 2026 or 2031 earnings is risky. The case in point is ShakeShack (SHAK), which is selling for over 210 times expected earnings for 2015 and has a market capitalization of $1.9 billion. This is for a company with 63 locations. Let's imagine that the company grows earnings by 20%/year for the next 15 years, and the stock sells for a P/E of 20 then. This would translate into earnings per share growing from 25 cents in 2015 to $3.85 by 2030.  This would mean that the stock price would be at $77/share in 2030. Right now, the stock is selling for $52.60/share. If everything goes right for the next 15 years on ShakeShack, an investor today would compound their money at 2.60%/year at best. If there is even the slightest hiccup along the way, the investor might not earn any return whatsoever. Check this article on what drives future investor returns.

I would much rather put my money to work in an established company like McDonald's (MCD), which sells for 20.90 times expected 2015 earnings and yields 3.50%. Assuming that earnings per share go nowhere for 15 years in a row, and the company never grows its dividend, I would likely generate a return of 3.50%/year. This of course assumes a worse-case scenario of complete stagnation in profits, which is unlikely.

So in other words, when I compare ShakeShack to a McDonald's, I choose the latter because it needs to jump through lower hoops than the former. Even if McDonald's does terribly at the operational level for 15 years into the future, they still stand a higher chance of delivering better shareholder wealth than ShakeShack (even if it grows at 20% per year for 15 years in a row). If ShakeShack is available at a much lower entry price however, then this would change the whole calculation. Let's circle back at the end of 2030, and see how this turned out. If you think the last sentence is preposterous, then it is very likely that you are not really a long-term investor.

I have personally tried to focus on small cap companies, and then attempted to determine which one can grow larger. For example, I was trying to determine if there are small banks out there, who will be able to grow into a Bank of America for example in several decades. After spending a lot of time looking for resources, browsing those resources, and looking at bank companies, I gave up. There was so much information that I decided not to go there. This is  because the potential for profit was not worth the time given the probability of failure relative to selecting an already established player in the industry. And I was also asking myself the wrong question. The right questions are:

1) Whether a company can grow earnings per share over time (assuming I understand the business)
2) Whether I can acquire it at a cheap enough price so that my income and wealth can compound (assuming no other better alternatives for my cash)

I believe that if I purchased more Wells-Fargo (WFC) when these criterion are met, I should do well over time. Actually at this time the company yields 2.90% and sells for 12.40 times expected 2015 earnings. As a holder of the stock, I believe that an investment of my money today in Wells-Fargo could deliver satisfactory growth in dividend income and principal over the next 20 years.

So to summarize, I do not think it is efficient to start my search for quality investment by starting with sectors or specific size companies, and only then search for individual companies. Instead, I start my search for dividend growth stocks, by applying a set of criteria on the list of companies with an established track record of dividend growth. I focus on companies that meet my predetermined criteria, and try to build positions in them slowly as long as they sell at attractive valuations. Size is not one of my criteria for inclusion/exclusion.

Full Disclosure: I own everything mentioned here, except for ShakeShack

Relevant Articles:

What drives future investment returns?
Common Misconceptions about Dividend Growth Investing
Frequently Asked Questions (FAQ) About Dividend Investing
Dividend Champions - The Best List for Dividend Investors
How I Manage to Monitor So Many Companies

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