Monday, April 21, 2014

Seven Sleep Well at Night Dividend Stocks

For my retirement, I am planning on relying exclusively on income from my dividend portfolio. In order to achieve the dividend crossover point, I would need to be prudent about saving and then investing the cash in quality income stocks at attractive valuations. The valuation part is generally easy to convey using simple numerical equations such as:

1) A ten year record of annual dividend increases
2) Annual dividend growth exceeding 6%
3) A Price/Earnings ratio below 20
4) A dividend payout ratio below 60%
5) A minimum yield of 2.50%

I usually run this screen on the dividend champions list once a month and come up with ideas for further research or with alerts that stocks I like are attractively priced. The more difficult task is evaluating quality when it comes to stocks. It is often said that beauty lies in the eyes of the beholder. When assessing quality in income stocks, I am often finding that what I identify as quality might be trashed by someone else.

In general, a quality company is the one that has strong brand name products and services that customers are willing to pay top dollar for. The products/services associated with this brand name represent quality, and offer something of value to consumers that is only offered by this company. When a company is offering something that is uniquely distinguished, and is not a commodity, it can then charge a premium and can pass on cost increases to consumers if input costs increase.

For example, you can purchase Cola products from many companies including PepsiCo (PEP), RC Cola and Coca-Cola (KO). However, for many consumers throughout the world, Coca-Cola offers a refreshing taste that is unique to the product they like. Even if someone was able to reverse engineer Coke, they would not be hugely successful because they would offer a largely untested product that the consumer is not familiar with. The company has managed to increase dividends for 52 years in a row, and pays an annual dividend of 3%. Check my analysis of Coca-Cola.

The same is true for PepsiCo (PEP), which is a close rival of Coke in the Cola Wars. PepsiCo however is much more than a soft drinks company. It also sells snacks to consumers such as Lays potato chips. The food business is incredibly stable, as consumers are typically used to buying the brands they trust on their trips to the grocery store. In addition, it is much easier to charge higher prices for your product that the customer likes.The company has managed to increase dividends for 42 years in a row, and pays an annual dividend of 2.70%.  Check my analysis of PepsiCo.

Another quality company is Wal-Mart Stores (WMT), which is used by 100 million shoppers every week. The company is offering the lowest prices for everyday items that shoppers ultimately purchase. Wal-Mart has been able to distinguish itself as the lowest price store as a result of its massive scale in the US. That has allowed it to dictate terms for its suppliers, many of which feel lucky to have their products on display at the largest retailer in the US. For a competitor to replicate this success, it would take an enormous amount of capital and years of experience. The company has managed to increase dividends for 41 years in a row, and pays an annual dividend of 2.50%. Check my analysis of Wal-Mart Stores.

International Business Machines (IBM) is a quality technology company that I have always found to be slightly over valued for my taste. I like the fact that the firm has been able to successfully transform itself into essentially what is now a global consulting company, from the pure hardware behemoth it once was in the 1980’s and early 1990’s. The firm has achieved that by building relationships with clients, gaining their trust and offering them services that provide them great value. In business, relationships are very important. Technology is one aspect of the business, where companies are less likely to venture with an unknown firm simply to save a few bucks. It would be much easier to justify selecting a company like IBM for an important technology implementation, than a little known firm. Plus, if the IBM consultants have a working knowledge of a company or industry, they would be much better at delivering value for their clients. The company has managed to increase dividends for 18 years in a row, and pays an annual dividend of 2%. Check my analysis of IBM.

Philip Morris International (PM) sells its Marlborough brand of cigarettes all over the world. Phillip Morris International has a high exposure to emerging markets, where number of smokers is increasing, along with their disposable incomes. Plus, it is not exposed to ruin if one country decides to ban tobacco outright. PMI has a wide moat, because it would be extremely difficult for a new company to start and compete against the long established brands like Marlboro. Consumers generally stay with the brands they are used to buying. Cigarettes are an addictive product, which spots very good pricing power. In addition, PMI has the economies of scale which ensure that its costs stay low relative to the competition. The company has managed to increase dividends for 6 years in a row, and pays an annual dividend of 4.50%. This is why this is the security I like best.

Another firm I like is Kinder Morgan Partners (KMP). This master limited partnership has the longest network of oil and gas pipelines in the US. It also has pipelines transporting oil and gas in Canada as well. The beauty of pipeline business is that it is federally regulated, and that companies that build pipelines seldom have competition. In essence, they are natural monopolies that connect the operators of oil and gas wells with the refineries and other end users, while receiving a toll charge. The amounts of oil and gas consumed in the US is remarkably stable, which is why a company with little competition that manages to charge toll type rates that are indexed with inflation seems like a good idea. The company has managed to increase dividends for 18 years in a row, and pays an annual dividend of 7%. Check my analysis of Kinder Morgan.

The last company on the list is McDonald's (MCD). There are over 35,000 restaurants world-wide, which bear the name McDonald's. Over 80% of those restaurants are franchised, which means that McDonald's is earning a boatload of royalties off those restaurants merely for their right of using the strong brand name, without taking the risk and significant capital expenditures associated with restaurants. These franchise agreements last several decades, which all but ensures a regular stream of cash being sent to the headquarters. In many cases however, the company also owns the real estate under the restaurants ( both company and franchised), which is a hidden asset on the balance sheet, since many locations are on busy intersections and therefore extremely valuable. Plus, consumers like McDonald's, who is always quick to look for new opportunities for growth such as drive-through windows, new markets, change in menus, expanding store hours or drive-through lanes, etc. The company has managed to increase dividends for 38 years in a row, and pays an annual dividend of 3.20%. Check my analysis of McDonald's.

What makes this investments sleep well at night ones is the fact that their income is produced by a diverse set of divisions, geographies and products. Plus, I find them to be fairly valued in today's market, and I believe they have bright futures that would bring in more earnings and dividend income for shareholders in the decades ahead.

Full Disclosure: Long MCD, PM, KMR, KMI, KO, PEP, IBM, WMT

Relevant Articles:

How to be a successful dividend investor
When to sell your dividend stocks?
How to monitor your dividend investments
How to deal with new cash from dividend payments
How to Manage Your Dividend Portfolio


  1. While I can appreciate the growth stats behind the seven stocks you have chosen, I personally like to throw in a bit of an ethical screen for screening out some of the less ideal choices. For me, that would include Walmart (they are heavily anti-union) and Philip Morris (tobacco, need I say more?). Granted, the next tier of fast-food products (Coca Cola, Pepsico, and McDonald's) aren't necessarily less evil, but one that I can accept.

    What would be your second-string seven players?

    1. I am investing to make dividends, not to apply a subjective set of "ethical" criteria. I cannot find a single business out there which cannot be challenged because it violates someone's "ethical" criteria. If you are investing money, but you are not focusing on making money but something else, you are probably wasting your time.

    2. Another anonymous commenter...

      DGI, I'm a huge fan of your website and approach to investing. I pursue dividend growth investing for all the same reasons that you espouse. That being said, I draw the line on investing in certain sectors of the economy. Corporate HR policy is one thing; however, I cannot fathom benefiting financially from a company that sells cancer sticks or weapons of destruction. Yes, I agree that ethical investing is wrought with idealism. But if we blindly turn the other way when making investment decisions then aren't we essentially saying, "I'm OK with how you make money?"

      Anyway, it's just a thought. My comment was not meant to be a criticism of anything you stand for.
      Best regards.

    3. I invest to make money .I do not care what a company does as long as it is LEGAL

      I donate money to the causes I care about

      Gool Luck

  2. How about giving some parameters of what to pay for these stocks. In other words what is a fair price.

    1. Did you miss the parameters discussed at the beginning of the article?

  3. DGI has stated excellent points for sleep well at night dividend growth companies. 6 of the 7 are core holdings in my own portfolio. (Not a fan of Walmart). I would encourage dividend growth investors to take a long hard look at an industry too often overlooked, by virtue of its high capital expenditures, cyclical nature, and less than desirable current yields- but once you peel back the layers, looks more inviting.... Railroads!

    I can think of few industries that enjoy a wider moat business model than Railroads. Not like you can start a new one, nor can a railroad be imported from Asia.

    20 years ago RR were money losers, but that has changed dramatically and right now they are sitting on a sweet spot in the economic cycle that should provide for decades of profitable returns. There are only 7 major competitors- of which only 6 are available to investors. Each enjoys a virtual monopoly within its service area.

    I own 4, but my favorite is CNI for dividend growth investing because of its enviable track record:
    The last 18 years it has an annualized 16% dividend growth rate!

    I took the time to compile a simple table that includes CNI with each of the 7 companies in this article to illustrate my point. The table assumes a $1000 investment 10 years ago.

    The 1st column is the current dividend yield on cost.
    The 2nd column is the total dividends that would have been collected, over the past 10 years, on the $1000 investment.
    The 3rd column is the annualized rate of return over the 10 years- if the dividends had been reinvested.

    Two notes: PM data is from 2008-2013, which makes its numbers even more impressive.
    CNI dividends would be subject to 15% tax- which should be taken into account.

    KMP 30.9% $1,914 14.4%
    MCD 16.4% $871 17.5%
    PM 8.9% $365 13.2% (Since 2008, when PM became a stand alone Co.)
    CNI 8.9% $482 19.7% (U.S. holders would be subject to 15% tax)
    PEP 6.1% $397 8.6%
    KO 5.8% $366 7.5%
    IBM 4.6% $243 8.9%
    WMT 4.3% $229 5.7%

    Despite the 15% tax on CNI dividends, it remains very competitive with the group. With double digit dividend growth, it does not take that long for the current low yeld to overtake the bulk of the field, as shown in the table. And while total return is not the goal of dividend investors, it does not hurt to own a compelling total return- like CNI- which trumps even KMP- despite Kinder's overwhelming dividend payments.

    Just food for thought, for those looking for something beyond the ususal dividend lists- and willing to look out 5 - 10 years at what a seemingly "low yeld" can actually grow into.



Questions or comments? You can reach out to me at my website address name at gmail dot com.

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