This is a guest post by Mike, aka The Dividend Guy. He authors The Dividend Guy Blog since 2010 and manages portfolios at Dividend Stocks Rock. He is a passionate dividend investor.
I had the chance to start my investment journey at a relatively young age, I was 22 when I made my first trade on the stock market. Back then, I didn’t have a detailed investment process designed. If there is one thing that I have learned since then is that investing success goes through a solid investment process. If I want to build a strong portfolio, I must have a strong methodology to select the right companies. This is the way to go for any investing strategy, and it is also the case for dividend growth investing.
I’ve noticed that not all dividend investors think the same. To my surprise, there are some important differences between most of us in the manner in which companies are selected. For example, I’m definitely not a yield seeker. In fact, if there is one thing I don’t consider during my investment selecting process, it is the dividend yield! I focus on the dividend growth as a pillar of my investing strategy. I’ve established 7 investing principles around dividend growth to manage my portfolio.
I wanted to share these principles with you by giving you eight examples of companies that meet my investing criteria and should create a solid base for any dividend growth portfolio.
[drizzle]Principle #1: High Dividend Yield Doesn’t Equal High Returns
Many investors give greater consideration to the actual company dividend yield or the payment in dollars they receive each month. I often read remarks from retirees telling me it’s easier for younger investors to focus on growth and that retirees don’t have time on their side and they can’t wait to see a dividend payment increase.
My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%.The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly come with dividend growth and this is what I am seeking most. The fact is that almost all companies paying over 5% yield are not able to increase their payout each year. Their management eventually struggles to make their payment and there is an inevitable cut.
In order to validate this point, I look at the dividend payment and compare it to the stock yield over the past 10 years. An increasing yield without an increasing dividend payment is a strong red flag as it tells you that the stock price is dropping. On the other hand, you want a company with strong dividend payment increases and a steady yield. This leads you directly to the jackpot: both capital and dividend growth!
A great company meeting my first principle is Walt Disney (DIS). Back in 2010, the company paid a total of $0.40/share for a very low yield around 1%. Many income seeking investors are ignoring DIS for this reason. In 2016, the company is currently paying a 1.50% dividend yield. Here again, nothing to write home about. However, did you know that DIS pays over three and a half time its 2010 dividend payout? If you would have bought DIS in 2010 at $37, you would be yielding 3.80% on your investment. And I’m not counting the astonishing stock return. This has been possible because the company successfully manages its brand portfolio. ESPN has been the company’s most important growth vector over the past few years, but as it is currently cooling down, theme parks and movies divisions are picking up to keep the growth pace.
Principle#2: Focus on Dividend Growth
My second investing principle relates to dividend growth as being the most important metric of all. It doesn’t only prove management’s trust in the company’s future but it is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?
This is why I focus on the company’s dividend payment history. In order to maintain dividend growth year after year, a company must show the following fundamentals:
Solid business model;
A protected economic moat;
Increasing cash flow;
A great company showing the perfect dividend growth profile is Genuine Parts (GPC). This company is part of the highly selective Dividend King group which includes only companies that has been consecutively increasing their dividend payment for at least 50 years.
Through a great combination of organic growth and growth by acquisitions, GPC was able to extend its business year after year and rewarded their investors at the same time. The automobile parts industry is a repetitive business enabling consistent growth and GPC benefits from a great expertise in acquiring smaller competitors.
Principle #3: Find Sustainable Dividend Growth Stocks
Now that I know I should focus on dividend growth and not dividend yield, I need to find indicators telling me this growth will continue into the future. As investors, we are more concerned about the future than the past. This is why it is important to find companies that will be able to sustain their dividend growth. This is where I take a look at three main trends:
#1 the dividend payment
#2 the payout ratio
#3 the cash payout ratio
I’ve selected Procter & Gamble (PG) to show you the difference between the payout ratio and the cash dividend payout ratio:
This graph shows me how their dividend payments evolve over time compared to the company’s ability to pay them. The most important thing is to consider the cash payout ratio instead of the most known payout ratio. Because net earnings can be easily manipulated and cash flows are harder to manipulate, this ratio is useful to analyze cash flow being paid in dividends.
Therefore, you can clearly see that even if Procter & Gamble posted lower earnings in the past couple years (leading to higher payout ratio), the cash dividend payout ratio has been relatively stable around 60% for the past four years.
Principle #4: The Business Model Ensures Future Growth
While looking at payout ratios will give you some hindsight about the future dividend growth of the company, metrics don’t tell you everything. Another way to validate if a company will be able to maintain its dividend growth rate is to analyze its business model. I often tend to look at companies that have a strong economic moat or that show hard-to-replicate competitive advantages.
A good example meeting this investment principle is the asset manager BlackRock (BLK). BLK has the largest market share for assets under management (AUM) and is a leader with its iShares division. With over $1 trillion invested in its ETFs, Blackrock shows more than double the AUM of the second-place State Street Corp. (NYSE:STT).
BlackRock offers a variety of products from fixed income to equities, therefore, when a mass of investors are leaving equities to move toward fixed income, BlackRock continues to sell them investment products. With new legislation coming from the Department of Labor (DOL), employers will