Dividend Focused Investing
October 18, 2013
In our free report: What Every Christian Investor Needs to Know, we drew several conclusions regarding how the Bible instructs us to manage our investments. We are given instructions to practice wisdom and due diligence. We are to understand and accept that uncertainty, also known as risk, is an unavoidable part of life for believers and non-believers alike. We are taught to practice diversification of risk. We are taught not to ignore history. We are taught to maintain awareness of various types of risk, and to draw reasonable conclusions based on evidence. We are taught to maintain discipline, letting wisdom, analysis, and planning drive our decisions, rather than emotions such as fear and greed. Finally, we are taught to avoid tainted wealth.
Avoiding tainted wealth can easily be applied to most strategies by using a moral screening process. However, we have quite a bit more criteria to satisfy. I believe that it's wise to view stocks primarily as income producing assets. Yes, capital gains are a huge part of the overall return equation, but they are also very uncertain. It's much easier to predict a company's next dividend payment than to predict what the price will be at that same future point. Further, a dividend focused strategy, if executed successfully, will also lead to attractive capital gains. That's because earnings and dividends can continue to grow significantly over time, even with companies that have decent current yields. Indeed, a dividend oriented investment strategy is one of the easiest and most effective ways to ensure that we satisfy the other requirements of avoiding emotion, and using discipline, wisdom, and analysis.
For example, we can perform a lot of due diligence in a few simple steps by reviewing a company's track record of dividend growth. There is so much information contained in a long track record of dividend growth. Take a moment to think about all of bad times the U.S. economy has experienced in the last 40 years. There was an OPEC embargo that caused a 16 month recession from 1973-1975. There were 3 more recessions in 1980, 1981-82, and 1990-91, which included the first Iraq war. There was the stock market bubble that ballooned in the late 90s and began bursting in 2000. Then, there was the recession of 2001, coinciding with 9/11. There was the Afghanistan, then Iraq wars. There was high unemployment with many college graduates settling for menial jobs that had nothing to do with their degree. Finally came the financial crisis and the "Great Recession" starting in 2007 and officially ending in 2009. Though it ended, unemployment has remained high through the 4 years after the recession ended. It appears that huge numbers of workers have permanently left the workforce.
Through it all, there are at least 52 U.S. companies that managed to pay more in dividends each year than they did the year before. This includes such recognizable companies as Lowe's (LOW), Colgate-Palmolive Co. (CL), and PepsiCo (PEP). A 40 year track record of increasing dividend payments tells investors a lot about these companies, their cultures, corporate governance, policies, products, positioning, and strategies. There is proof that what they have done in the past has worked very well. If none of those things has fundamentally changed for the worse, we can probably expect these companies to continue paying and even growing their dividends well into the future. These companies have managed not just survive, but even thrive through very tough economic conditions. It makes a case that the odds are good for these companies to continue offering good returns to shareholders going forward. They face risks just like any other businesses. They are not "sure things". Things could happen that negatively and severely affect their business. But with a track record like that, a dividend focused investor really should be looking for reasons not to invest in these companies. The reason for investing is already a given.
There are several other practical reasons to consider becoming a dividend oriented investor. The first and most obvious reason would be that you want or need the current income. If you are in retirement and could use 120 checks in the mail every year, you may want to invest in a basket of 30 stocks that have nice yields and a long track record of continuously paying, and even increasing dividends. The current income from such stocks could realistically be in the range of 3-5% without taking a lot of risk. That may not sound too exciting until you realize that it's 3-5 times the amount of income you would receive from investing in CDs (the best 1 year CD rates in June 2013 are around 1%).
Another reason is to be able to screen for and identify companies that are in the middle of their natural growth cycle. When I see a company that has a track record of growing its dividend every year for 25 years, I think, "Wow. That was a great investment 25 years ago." It could still represent a great investment today, but it's more likely to be a stable, low risk investment that will result in decent returns. In other words, it could still be a good investment, especially on a risk-adjusted basis. That is, if the stability of the company's cash flows result in low risk to investors, but still generate decent returns.
But when looking for investments that will generate above market average returns, one must consider the natural growth phases of a product or company. The natural growth cycle of a company is that it slows over time. Some companies defy the odds and continue growing rapidly for long periods. They generally do so through successful innovation, acquisitions, or expansion into new markets and product lines.
In the case of Wal-Mart (WMT), they just steal market share from everybody else, ultimately putting a lot of their competitors out of business. This brings me to a good point. It would be very nice to find the next Wal-Mart right after it goes public. Indeed some websites and financial writers love to point out how easily you could have become a millionaire if only you'd invested in Wal-Mart back in 1970 and held it until today. But how realistic is that? I wondered what the company looked like back then, so I pulled up the oldest shareholder report I could find, from 1972.
At the end of 1970, Wal-Mart was operating 32 discount stores. Even at the end of 1972, they had only 51 stores in 5 states. The 1972 annual report contains "Words from The President", in which Sam Walton writes, "Our growth potential lies within the magic circle - an area that encompasses northern Arkansas, southern Missouri, southeastern Kansas, and eastern Oklahoma." He goes on to state that there is a "balance of tourism, industrial jobs and agriculture that should continue to encourage a healthy growth in this Ozark region for years to come. Our Management and your Board of Directors have indicated they want the Wal-Mart program to continue in its present direction by growing internally through the improvement of our existing stores and continued expansion within our five state area." Maybe, at that time, you could have seen the global behemoth that Wal-Mart would become, but that would make you more of a visionary than Sam Walton himself. If you had read their annual report in 1972, you may have gotten the impression that Wal-Mart had no interest in becoming a nationwide, much less global company. It sounds like their plan was to focus on growing in "this Ozark region for years to come." The point is this, unless you lived in one of those 5 states, I think it's more realistic to have gotten interested in the stock during the late 70s or early 80s when a Walmart made it to your town. Maybe you wouldn't have paid attention until the early to mid-90s, when you first saw that they were putting grocery stores out of business. It was at these times you could have visually observed the power of "the Wal-Mart program", and understood that it was working in more than just "this Ozark region." In the 80s and 90s, Wal-Mart probably didn't seem quite as limited or quite as risky. An investor could have more easily developed a conviction that this was a solid company that was going to be around and growing for many years to come. An investment, assuming reinvested dividends, from January 1st, 1984 to today would have returned 83.3 times the original amount (15.9% annualized). An investment from 1/1/94 to today would have returned roughly 6.6 times the original investment (9.9% annualized). Yes, such an investor would have done just fine despite having waited until a more solid track record was established.
So, that brings me to an interesting question. How was Walmart stock finding its way into investment disciplines back then? Walmart started paying a dividend in March of 1974, and has raised it every year since. A dividend oriented investor probably would have started really taking notice of their track record by 1984. This is just one example, and yes, it happens to be a very good one. However, it is a realistic example of the type of situation you might look for as a dividend investor. When a company has maintained a track record of increasing dividends each year for 10 years straight, they've managed to make it through at least one recession. Not only that, they've managed to do well enough to continue increasing the amount of money they return to shareholders in spite of challenging circumstances. Obviously, a company that has done so for 20 years straight has proven even more about how sound is their business, product lines, culture, and management. But it makes sense to look for a sweet spot between having a solid track record, and still having plenty of room for growth.
In regard to the companies with longer track records of dividend growth, you definitely shouldn't ignore them. However, you should see them for what they generally are: stable companies capable of providing investors with nice risk-adjusted returns. You shouldn't see them as fueling the real growth of your portfolio. They will result in some growth, but you should manage your expectations. You can't buy Lowe's Inc. (LOW) stock expecting it to take off like a rocket. If LOW were to, on average, double investors' money every 8-12 years, investors should be fairly happy. That's because LOW is a relatively low risk stock. The company and business is very stable, having increased its dividend payouts each year for 51 straight years. Even if the price drops sharply when "the sky is falling", it won't drop as much or for as long as other companies without such a track record. Stable dividends cause the price of a stock to be propped up during bad times, resulting in less volatility, all else equal.
Further, if you are focused on dividends, you are less likely to make mistakes in your investing. If the dividend payment is a large part of why you invested in a stock, you won't be coaxed into selling at exactly the wrong time. In Feb. 2009, everyone was running scared. The sky was falling. The developed economies of the world were all on the brink of collapse. It was the worst financial crisis of our lifetime. Even solid dividend payers got hit hard. Pepsico, Inc. (PEP) had fallen from its Dec. 2007 high of $78.46 all the way to $47.10. It might have been easy to panic along with everyone else, unless you were a dividend oriented investor. If you were focused on that aspect of your investment, you could have taken comfort in the fact that PEP was in its 37th straight year of increasing its dividends. Hopefully its obvious why staying focused on dividends can help reduce the chances that you will make mistakes. There are plenty of companies out there with stable dividend payment histories - much more stable than say, market price fluctuations. Focusing on this stable aspect of your investment may help you to avoid panic. It will help you, instead, to see selloffs as buying opportunities, since the dividend yield will look more and more attractive as the stock falls.
There are other reasons to view solid dividend track records positively. First, it imposes a strong discipline upon company management. When companies are awash in excess cash and not paying a dividend, they tend to make acquisitions that expand their empire (and by extension, their salaries) but add little, no, or negative value to shareholder wealth. Alternatively, they can use cash to buy back stock, even as they continue to create new shares to hand out to senior managers. As investors, we should strongly prefer dividends. I'd rather have the money in my hands. Second, consider that the dividend track record is generally very important to company management. They are very hesitant to cut or eliminate dividends. They tend to do so only when it is absolutely necessary. There are varying reasons for this. For example, many institutional investors have strict rules for their investments. A common one is that they can only invest in companies which pay a dividend. A lot of individual investors also strongly desire stability in dividend payments. The dividend may be the primary reason why many investors hold the stock. So, management wants to avoid cutting or eliminating dividends if at all possible. If they believe a cash flow problem in the company is temporary, they will avoid making the cut.
If company management believes the problem is temporary, that says a lot. No one knows the company better than they do. Further, if management has chosen to increase the dividend, it is a signal that they believe they will be able to continue paying the higher amount indefinitely. In other words, it is a signal that they believe their cash flows are solid and will continue to grow going forward. It's good to read annual reports and carefully analyze what company management says about the health and prospects of the company going forward. But it's more meaningful to analyze their actions. Significantly raising the dividend, for companies with an already solid track record, is an action that carries some weight behind it. The ability to do so each year for many years tells me a lot about the stability of the company, the competence of its management, the success of its culture, strategies, and products. The bottom line is this: the dividend track record represents valuable, easy to understand information that investors would be wise not to ignore.
Interested in checking out specific dividend oriented investment opportunities? Check out our Dividend Focus reports here.
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At the time of publication, the author does not hold any positions in any of the securities mentioned and has no plans to initiate positions in those securities within the next 72 hours. The views expressed are the opinions of the author and do not necessarily reflect those of Wisdom’s Reward, LLC.