Tuesday, October 6, 2015

Quality Dividend Stocks versus Growth Stocks ( Part 2)

This is a continuation of the article I posted yesterday.

I focus on companies that provide essential products and services to their consumers. These customers use those products and services on a regular basis, and are usually loyal to those companies. The companies I focus on tend to be boring and enjoy slow but steady growth over time. These are our well-known dividend growth stocks. My favorite list is the one that David Fish updates every month.

These boring companies generate so much in excess cash flow, that they decide to remove temptation from management, and send that cash to shareholders. These companies do not need to use all of their profits in order to grow and maintain their competitive position. This is because there is little disruption in the way people eat, drink or take care of personal hygiene. Despite all of that, most companies are able to sell more, innovate, and generate more revenues. This all translates into more profits, more dividends and incidentally pretty decent total returns.

In fact, many of these great cash machines tend to get in the habit of continually raising dividends to their loyal shareholders, every year like clockwork. These companies prefer loyal long-term shareholders, and not a bunch of super caffeinated daytraders. The dividend payment is portion of the total return that is always positive, more stable than capital gains, and can never be taken away from you. In my reviews of individual dividend champions, which lists companies that have managed to regularly increase dividends for at least 25 years in a row, I have uncovered quite a few that were able to achieve this no small feat because their businesses were outstanding. There are only 106 companies on the dividend champions list, out of at least 10,000 publicly traded companies in the US, which explains why membership in this elite list is a small miracle.

These slow moving companies are always ignored by a vast majority of investors, because no one in their right mind would believe that such investments could produce outstanding returns over time.

However, it is not difficult to understand how they result in greatness. These companies have an economic engine that grows earnings regularly, and this results in regular dividend increases. Dividends get redeployed to work for the shareholder into more dividend paying securities, thus starting the compounding snowball process. I witnessed firsthand the benefits of regular cash dividend payments during the 2008 – 2009 financial crisis, when most investors were scared and were selling off shares like there was no tomorrow. Most dividend investors however were getting the fresh dividend payments deposited into their brokerage accounts, and were deploying this capital at depressed valuations.

These enterprises quietly compound earnings, and dividends over time. They are best suited for semi-passive investors with a long-term horizon of at least 20 years. A prime example includes Johnson & Johnson, which sold at a split-adjusted value of $7.42/share in 1989, and paid a measly $0.145/share, traded at a P/E of 18. Fast forward 25 years since then, that share costs $93.93 and pays $3 in annual dividend income. As a result, you can see that a dividend investor not only received a positive return through cash dividends each year, but they also had capital gains in the process. An investor who put $1000 in the security, and spent dividends every year would be nevertheless earning a double digit yield on cost ( a 40% yield on cost to be precise). Had they reinvested dividends, their yield on cost would have been even more impressive. And the best part is that investors can still participate in the future upside potential in earnings and dividends.

If you manage to purchase a diversified portfolio consisting entirely of dividend champions from as many sectors that make sense, and you pay fair prices for those pieces of businesses, you have pretty good odds that your portfolio will be able to generate higher dividend income to you as a shareholder over time. How do I know this? I don’t know what the future holds, but based on my reviews of dividend champions from 1991, 1994, 1999, 2005 and between 2008 – 2014, I believe that dividend growth stocks offer a so called edge to long term investors. As with the Johnson & Johnson case above, the real fruit was harvested 20 – 25 years later. And it does make sense that a company yielding 3% today and selling for $100/share today could end up paying over $6/share in annual dividends in ten years.

Some of the dividend growth companies of today will get acquired, will merge with others and spin-off subsidiaries during this time. Examples include Philip Morris, which acquired General Foods and Kraft in the 1980s, and then subsequently merged them and spun-off as Kraft in 2007. Philip Morris was renamed to Altria (MO) in the early 2000s, and it also spun-off international tobacco operations as Philip Morris International (PM) in 2008. Another example includes Anheuser-Busch ( BUD), which was acquired for $70 in cash in 2008, after rewarding shareholders with dividend growth for 30 years prior to that.

A small portion of those today will likely fail over time, thus cutting dividends at some future point of your investment. However, this statement is very misleading, because you never know how long it would take a company between your purchase date and its ultimate end date. If you purchased Bank of America at the highest price of 1987, when it became a dividend achiever, you ended up paying $7.28/share for a stock earning $0.21/share in annual dividends. Approximately 20 years later, the annual dividend is indicated to be $2.56/share for a yield on cost of 35.75%. Bank of America did cut dividends in 2008, but if you had sold right after the cut, you would have still received something like $30 for each share you sold. In addition, even if Bank of America went to zero after cutting dividends to the bone, the dividend investor would have still recovered their purchase price from dividends alone. But even for those companies that fail almost right away, the investor who monitors positions can sell after the dividend is cut or eliminated, and reinvest proceeds somewhere else, thus minimizing reductions in dividend income.

Another portion of the portfolio will remain outstanding, and keep increasing dividends over time. Some of those companies might keep raising those dividends every year, while others might freeze and resume dividend growth over time. An example includes Kellogg (K), which froze dividends in early 2000’s after raising them for over 4 decades. It resumed dividend growth a few years later, and never cut distributions. Hershey (HSY) is another example of that phenomenon, as it froze dividends in 2009, but then resumed growth in the subsequent year. While this ended its streak of 30 years, holders of Hershey kept receiving sweet dividends throughout the financial crisis. Dividends per share have been growing since 2010.

In summary, a diversified portfolio of quality dividend growth stocks will not only help in building wealth over time, through compounding of earnings, dividends over time. The constant growth in earnings and dividends also makes businesses that deliver them more valuable over time. Add in the compounding effect of reinvested dividends, and you have a trifecta that will deliver high net worth and growing dividend income for you.

Full Disclosure: Long K, PM, KRFT, MDLZ, MO, KO, PG, JNJ, IBM, XOM

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