There are many investing strategies and principles that retired investors can utilize to reduce the risk associated with investing in equities (stocks) for their retirement portfolios. Choosing to invest in the highest quality stocks your mind can conceive sits at the top of the list. There are many components that investors can analyze and examine to determine whether a company is high quality or not.
The primary determinant of high quality is superior financial strength. Financially strong companies possess the staying power and resources to weather the occasional bad storms that will inevitably occur. Every business will on occasion face challenges and difficulties. Meeting those challenges requires a strong balance sheet and an adaptive and competent management team to guide the company across troubled waters.
Evaluating financial strength can be accomplished through the examination of a few simple but important fundamental metrics. Fortunately, much of that work is already done for us by established and reputable reporting agencies such as Standard & Poor’s, Value Line, MorningStar, etc., in the form of credit ratings.
There are many available sources where retired investors can find that information. The key is to look for companies that are awarded what is referred to in financial circles as investment-grade ratings. Typically, the companies with the best ratings will have a capital A or better in their credit rating.
[drizzle]Retired investors concerned with safety can dig deeper by examining important fundamentals such as cash flow, free cash flow and debt levels. Stated overly-simplistically, you will be looking for companies that have the strength of cash flows to support debt payments and current and future dividend distributions. Regarding safety considerations, cash flows are more relevant than earnings. Because when it comes to the survival of a business, cash flow is king. As it relates to safety, a business surviving as an ongoing concern is the last line of defense.
Additionally, when it comes to determining the safety associated with investing in a stock, determining whether it possesses superior financial strength is an obvious and commonly-utilized approach. However, there are additional important safety measurements that are more subtle, less understood and often either ignored or their importance not given the credit deserved.
These more subtle safety measurements are an above average, but sustainable, current dividend yield and sound valuation, or better yet, significant undervaluation. The remainder of this article will examine the financial strength and these two important but more subtle safety measurements as they apply to the much-maligned blue-chip stalwart IBM.
IBM’s Financial Strength
IBM was founded in 1910, and Incorporated in the state of New York in 1911. The company took on the iconic IBM name in 1924. Consequently, IBM has been an American technology stalwart even before technology became cool. As such, IBM has been long-renowned as a blue-chip dividend growth stock. So much so that legendary investor Peter Lynch once quipped “no one ever gets fired for buying IBM.”
Here are IBM’s Credit Ratings from 3 Reputable Sources:
Standard & Poor’s: AA-
Value Line: AA+
IBM Liquidity Ratios
IBM’s current ratio (crq) is and has been above 1, indicating that the company is fully capable of paying its obligations. IBM’s quick ratio (qrq) also supports its ability to meet short-term obligations. Importantly, both of these ratios continue to remain within IBM’s historical norms.
IBM’s Dividend Yield, Record and Sustainability
In the title of this article I sarcastically included the phrase “it’s about the income stupid.” However, I was not merely attempting to be sardonic, because that phrase represents a significantly important principle about investing in large blue-chip dividend growth stocks. Regardless of whether you’re investing in revered blue chips such as Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO), or IBM (IBM), etc., it would be naïve on your part to believe you will automatically or always outperform the market on a total return basis.
Behemoths such as those described above have simply become too large to grow fast. Their primary appeal derives from their safety characteristics and the dividend income they have produced in the past, and are capable of providing in the future. In this regard, it would not be naïve to believe that these blue-chip dividend stalwarts might produce significantly more future dividend income than the general market, because in truth and historical fact, they all have – IBM included.
Stated more directly, investing in blue-chip dividend growth stocks is not about how much their stock price might appreciate. Instead, it’s about their safety and how much dividend income and dividend income growth they can provide retired investors long into the future. However, this is not to suggest that they do not possess the capacity for capital appreciation, because they all do. This is especially true if they are purchased at sound or attractive valuations. I will discuss the importance of sound and attractive valuation in more detail later.
This brings me to a specific discussion about IBM and its dividend history. This blue-chip stalwart has paid its stockholders a dividend every year, in fact, every quarter, since 1916. Moreover, it has increased its dividend for the past 20 consecutive years at a rate of approximately 15% per annum. As an important aside, this dividend growth rate is significantly greater than its historical earnings growth rate.
IBM’s Dividend Growth 1995-2014
Part of this can be attributed to the fact that its payout ratio has steadily increased from a low of 12% in 1996, to its 2014 payout ratio of 26%. But most importantly, IBM’s low payout ratio coupled with its strong free cash flow generation suggests that above-average dividend growth is likely to continue long into the future. When investing in IBM for your retirement portfolios, it’s all about the income.
When you examine the following performance results on IBM since December 29, 1995, I direct your attention to two important columns. The first column to review is “Dividends per Share” where you can see the consistent and significant growth of their dividend rate per share for each year. The second column I suggest you focus on is “Dividends Declared.” With this column you will see the annual growth of dividend income based on an original $10,000 investment. I contend that this is the primary reason for considering IBM in your retirement portfolios.
Next is the consideration of IBM’s high current yield of approximately 3.7%. This is significantly above the current yield of 2.2% for the S&P 500. In addition to the obvious income benefit, an above-average current yield also serves as an important safety attribute. In theory and principle, every dividend payment you receive from a dividend growth stock technically reduces the amount of capital you have at risk. Higher-yielding stocks like IBM are in essence reducing your risk every time they send you a dividend check. This minimization of risk is especially relevant when the above-average yield payments are growing as quickly as they are with IBM.
The following F.A.S.T. Graphs™ plots IBM’s historical current yields since 1996. Notice that this is the highest current yield that IBM has offered shareholders over that timeframe. In addition to the benefits cited above, this is also an important valuation measurement. IBM’s current valuation will be elaborated