Thursday, October 8, 2020

Dividend Growth Investing Principles

We have had some new readers join the Dividend Growth Investor website. As a result, I wanted to discuss briefly what Dividend Growth Investing is all about.

The basic premise of dividend growth investing is that companies that grow earnings can grow dividends over time, and can see increases in intrinsic values over time. Add in the power of reinvested dividends, and you have a decent picture of what to expect.

When you are paid a rising dividend to hold onto a stock, you can afford to be patient. You can sit out any temporary weakness, or situations where the valuation is stretched out for a while. 

This is quite obvious when you review long-term charts of dividend kings such as Johnson & Johnson (JNJ) and Procter & Gamble (PG).

You can see that in the case of Procter & Gamble, the company has generally managed to grow earnings per share for decades, since 1970.

Procter & Gamble has been able to grow its dividend for 64 years in a row. The last 50 of those years are visible in the chart above. That dividend growth was possible only because the company has a solid line-up from products, which face demand that is somewhat immune from recessions. In addition, the company has a durable moat, stable cash flows and had a lot of factors going for it. It had a long runway ahead of it, and a line-up of products that were not going to be made obsolete by technology. They were going to be aided by technology.

You can see however, that there were times when the share price went nowhere for extended periods of time. That was despite the fact that earnings per share and dividends per share grew during those times.  A few notable examples to focus on include 1972 - 1985 and 2000 - 2012. The reason for these periods is that the share price got ahead of itself for a while, so it took a few years to correct the imbalance. Share prices oscilate above and below intrinsic value. By the time of maximum pessimism, the pendulum swings to undervalued. At the time of maximum optimism, the pendulum swings to overvalued. Some great investors like Warren Buffett may be able to sell above intrinsic value and buy below intrinsic value. For the mere mortals like you and me, the best course of action is to buy and hold, and sit patiently, while collecting a rising stream of dividend payments. This is your fair share of the company earnings. This is your incentive to hold on to your shares as a long-term shareholder. Trading in and out of a stock is usually going to cost you, lead to frustrations, and lead you worse off than simply doing nothing.

While the intrinsic value of the business grew steadily, the share price did not grow steadily in lockstep each year. This is where new investors need to learn that equities do not just generate 10%/year every single year. There may be long periods of time with no or low returns, which test everyone's patience. During these periods of time, everyone starts questioning if buy and hold investing even works

By the time the weakest hands have sold, because they became discouraged from hearing bad news about the company they owned, the price starts reverting back to intrinsic value, turbocharging returns for the patient shareholders. This reminder should help you avoid the temptation to sell, because the amount and timing of capital gains is very uncertain and sporadic. As you can see from the chart above however, dividend income is more stable and dependable than share prices. 

In general, a Dividend Growth Stock is a company that has managed to grow dividends for a certain number of consecutive years. I look for ten consecutive years of annual dividend increases , but sometimes I look for 25 years, while other times I can live with a 5 year streak of annual dividend increases. It depends on the company.

The basic model is that a company can afford to grow dividends because it generates more free cash flows that it knows what to do with. Such a company usually has a strong business model, a moat or is riding some long-term trend. Either way, that streak of consecutive annual dividend increases is an indication of a quality business with growing earnings, which should be researched further.

I view dividends as a signal from management, which shows me their confidence in the near term and long-term prospects of the business. A company that can afford to grow dividends, shows me confidence in the near term business prospects. This is valuable information that things are going according to plan, particularly for a company with a long track record of annual dividend increases. 

However, if management is just growing dividends, while earnings are flat or not rising, this is a warning sign. That’s because without earnings growth, future dividends have a natural limit. Ultimately, flat earnings and rising payout ratios increase the risk of a dividend cut.

A company that cannot grow dividends usually serves as a warning sign that not everything is going according to plan. A lot of companies go through changes in the business model, economic environment or competition, which is why a dividend freeze is something that can be expected at some point. If this comes from a company with a long history of annual dividend increases, this shows that something is not working as expected. As an investor, I want the company that delivers rising earnings, rising dividends and rising intrinsic value over time. If I do not see that any more, I would likely keep the investment for the time being, but allocate new money and dividends elsewhere.

A company that ends up cutting or eliminating its dividend shows me that things have changed for the worse, and that it cannot afford a dividend any more. Usually this happens when the business is at risk, and it needs all financial resources available for survival. While the odds of reinstating the dividend and the business going under are perhaps equal, I see this as a change in fundamentals. I invest to see one outcome, following my thesis that things go up gradually over time. If they do not, and I am proven wrong, this shows me that my thesis was incorrect. If my thesis no longer holds, I sell a stock. Usually, I sell after a dividend cut or suspension. Most other reasons to sell have been a mistake. When things change and I receive information about this material change, I change my mind. Selling after a dividend cut is helpful, because quite often investors may fall in love with a stock, and fail to see objectively that the company is no longer the cash flow generating machine it once was. A dividend cut is a wake up call that the thesis has changed, so a course revision may be necessary.

When discussing dividends, investors often tend to view them either as great or terrible. In reality, things are much more nuanced.

There are two or three major types of companies. The first type includes companies that can reinvest all of their earnings at a high rate of return in the business, which can translate into high earnings growth over time. A lot of these companies do not pay dividends, because they reinvest everything back into the business. The problem with this approach is that a lot of these companies may hit a ceiling point, at which it would be difficult to find projects to reinvest all earnings at a high rate of return. As a result, once the company hits that ceiling, they start distributing dividends. No company in the history of the world has ever been able to reinvest all earnings back into the business at a high rate of return for extended periods of time. The ones that may have done it, have been more of an outlier than a trend.

The second type includes companies that generate a lot of excess cash flows, and they may not need all of that money to be reinvested into the business, in order for it to grow. Usually, these are companies in mature, slow growth industries. They can grow slowly over time, but only need a small fraction of earnings to reinvest back into the business. There is a natural limit to how much more capital can be productive put back into the business at a high rate of return. You may recall Warren Buffett’s discussion of his investment in See’s Candies, which generated over $2 billion in profits between 1972 and 2007, and needed an increase in working capital from $8 to $40 million during the same time period. They managed to grow slowly over time by raising prices, increasing productivity, eliminating waste from the system. While growth was slow, the company still managed to generate a lot of income over time.

There are various stages for dividend growth companies. The companies that are in the initial phase of paying and growing a dividend may have a lower payout ratio, but manage to grow the distribution faster than earnings per share, up until they hit a certain target payout ratio. Other companies are in a more mature phase, hence their dividend growth and earnings growth are fairly similar. A third group is in the decline phase, and they have been unable to grow earnings, which means dividends are at risk. 

There are also various types of companies depending on their payout ratios and dividend growth trajectories. 

Some companies have high yields, pay a large portion of earnings, but grow distributions at a low rate. Some utilities, telecom companies, REITs and tobacco companies are in this group.

Other companies are in the sweet spot, with average yields and average dividend growth.  Companies like Johnson & Johnson, Procter & Gamble and PepsiCo fit this bill.

A third group of companies has a lower dividend payout ratio, but they have higher growth expectations. A few examples include Visa, United Technologies and Cintas.

There may be a third type of companies, which cannot afford to pay a dividend. That could be because they cannot earn a profit or they need to reinvest all profits to stay competitive, without a corresponding impact on their profitability and intrinsic value. 

Now that you have a general idea of dividend growth investing, I wanted to mention briefly that a long streak of dividend increases is usually an indication of a quality business with a business model that needs to be researched further by the enterprising dividend investor. 

This analysis should include a qualitative, and a quantitative evaluation of the business. A qualitative evaluation would look at brands, moats, the competitive environment and likelihood for future growth/strategy. A quantitative evaluation should look at trends in earnings, dividends, payout ratios, revenues, return on capital, and capital allocation. It is imperative that the investor understand the business. Otherwise, they would be unable to get the conviction to buy and to hold on to it if things get tough.

It is very important to acquire a quality business at a very good valuation. If you overpay for a business, you may end up sitting at an unrealized loss or a small gain for years, even if the business grows revenues, earnings and dividends. If you overpay for a business, your dividend income would be smaller than a situation where you buy that business at a more adequate valuation. As you saw in the chart above, overpaying for Procter & Gamble in 1972 led to seeing the capital value of your investment go down substantially, before recovering and breaking even by 1985. The only return you received was from dividends. I doubt that many investors would be willing to sit for 13 years with little to show for it. Only a patient investor would have enjoyed receiving more in dividends, despite gloom and doom. When you overpay for a stock, you should be willing to sit out any overvaluation and not earn returns for a few years, before breaking even. It may or may not be worth for you to overpay for future growth that could take up to a decade to resolve itself. If you are patient enough, and plan to hold for 40 years, it won't matter at the end. If you are impatient, and want instant gratification, you may end up selling low and destroying capital and future compounding potential.

Today we discussed a simple mental model called Dividend Growth Investing. With this strategy, you have a quality company that grows earnings, and raises dividends regularly for a long period of time. This growth in earnings and dividends typically leads to growth in intrinsic value. Reinvestment of dividends also increases net worth for the investor. This long streak of dividend increases is the quality factor that piques the interest of the enterprising investor, who places the company on their list for research, before deciding if the business, the fundamentals and the valuation are right for their portfolio. 

Relevant Articles:

What is Dividend Growth Investing?

- Buy and hold dividend investing is not dead

What Dividend Growth Investing is all about?

Common Misconceptions about Dividend Growth Investing

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