Tuesday, June 16, 2015

The most important metric for dividend investing

When selecting a dividend stock, investors should look at the dividend last. Income investors should first focus on profitability when investing in dividend paying companies. Investors should attempt to gauge whether companies can increase earnings in a sustainable way for the next decade. For master limited partnerships I would focus on Distributable Cashflow per Unit (DCF), while for REITs I would focus on estimated growth in Funds From Operations (FFO). Investors should not focus simply on revenues. They should also be beware of CEO’s who are empire builders or sales groups whose only goal is commissions, not company profitability.

In many cases, investors take into account unimportant pieces of information, which nevertheless influence their decisions. These investors should not focus on news stories and popular opinion, but should instead focus on the cold hard data.

I believe that rising earnings per share are very important when it comes to investment selection. They are important in conjunction with getting a good price of course, and placing that investment in a well diversified portfolio.

Companies increase earnings by raising prices, cutting costs, introducing new products, acquiring competitors, expanding in new markets, increasing volume to name a few. I have highlighted below a few companies, which exhibit rising earnings per share.

The first company is Altria (MO). Any time I mention Altria or investing in tobacco, I receive a ton of feedback about the end of cigarettes and the tobacco industry. I am not arguing that the tobacco industry could well be decimated in the next 20 years. However, this is a possibility for many industries as well. In addition, popular opinion has been that tobacco is a dying industry for the past 30 years. And those 30 years have been pretty good when it comes to investment results by tobacco companies. Many detractors of tobacco investments often point out to the fact that tobacco usage is decreasing in the US. They are correct, but their statement is missing the forest for the trees. It is interesting to observe that while usage has been declining, companies like Altria (MO) have managed to keep growing earnings per share.  Companies like Altria have achieved this by increasing prices faster than the rate of decline in consumption, and cutting costs in the process. In addition, the fact that it is illegal to advertise tobacco products, has made it easier for tobacco companies to maintain their branded monopolies despite years of adversity. This possible is because demand for cigarettes is inelastic, which means that a one percent increase in cigarette prices results in a decrease in consumption of less than one percent. Therefore, companies like Altria generate billions each year in free cash flow that they cannot deploy, and they do not really need much capital to maintain operations. Hence, they return that cash to shareholders in the form of dividends. I actually like the company at a 17.30 times forward earnings and a dividend yield of 4.30%. If I didn't own so much Altria, I would be buying the stock these days. Check my analysis of Altria (MO).

A stark contrast to Altria (MO) is PepsiCo (PEP). The company is actually selling more of its products, but also charging more for them over time. At the same time, PepsiCo has been opportunistic in growing through acquisitions, and constantly cutting costs and streamlining operations. PepsiCo is both a snack company and a beverage company. It is entirely possible that some day snacks and most carbonated beverages will be viewed with suspicion by consumers. However, for those who still want to get a treat after a hard day at work, those snacks and branded beverages will be there, and will likely still have pricing power. It is important to realize that just growing sales for the sake of growing sales is dumb. It is much more important to focus on the most profitable consumers for a company. I like PepsiCo (PEP), which is trading at 20.80 times forward earnings and yields 3%. As usual, I would find it attractive below $90/share. Just like with Altria however, I own too much PepsiCo already. Check my analysis of PepsiCo

Both companies are consumer staples, which has historically been one of the best sectors for creating wealth and rising dividends. It is interesting to note that the first company, Altria, manages to grow earnings per share and shareholder wealth despite decrease in usage. This is in contrast for a company like PepsiCo, which is firing on all cylinders, and likely has years of growth ahead of it, in both revenues and earnings. In addition, both companies earn high returns on invested capital, which results in lower capital needs, and a lot of excess capital to be distributed to shareholders. It is also nice to know that the products that Altria or PepsiCo sell, do not have an expiration date. Even if 20 years, a Pepsi will be a Pepsi. Provided that the law has outright made cigarettes illegal ( possibility of that is low), smokers who like smoking Marlboro, will keep smoking Marlboro.  This is not the case with many pharmaceutical companies however - many of their products have a limited life of less than 20 years.

Pharmaceutical companies have to invest large amounts in R&D expense each year, in order to have a drug come to market several years down the road. Those of us who like studying business, accounting, and applying that knowledge to reading annual reports know that research and development is the capital investment equivalent for pharma companies, which flows through the income statement. Thus if a company foregoes investment in drugs, they could show an increase in earnings over a short period of time. This is because profits will not be hindered by expensive lab research. However, once patents expire, earnings will take a dive from which they will never recover. The fact that I do not understand drugs well enough, have left me to invest mostly in diversified healthcare companies which happen to have pharmaceutical exposure. Such companies include Johnson & Johnson (JNJ) and Abbott (ABT) prior to its split in 2013. When you have products with longer shelf lives to offset potential patent cliffs in various drugs, you can afford to grow earnings and pay higher dividends.

Full Disclosure: Long MO, PEP, PM, ABT, JNJ,

Relevant Articles:

What makes Consumer Staples the Perfect Dividend Growth Stocks
The work required to have an opinion
Rising Earnings – The Source of Future Dividend Growth
Should dividend investors hold on to Abbott (ABT) and Abbvie (ABBV) following the split?
Buying Quality Companies at a Reasonable Price is Very Important

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