Seeking Alpha
Value, special situations, research analyst, registered investment advisor
Profile| Send Message| ()  

I doubt I need to sell income seekers on the importance of dividend growth since that is what it usually takes to entice someone to invest in stocks rather than bonds. But how do you identify good dividend-growth candidates?

Many eyeball or create screens based on historical rates of dividend growth presuming that companies with good track records of increasing dividends will continue to do likewise. That notion is not necessarily wrong. I created a basic stock screening strategy (see appendix below) that identifies good- to moderate-quality income candidates and sorted based on historic dividend growth to identify the top 15 candidates. A hypothetical portfolio based on the screen as a whole (before sorting based on dividend growth) posted an average annual return of 9.58% over the past five years, versus 2.06% for the SPDR S&P 500 TRUST (SPY); both figures include returns from dividends. (NOTE: I rebalanced the portfolio every three months, and the tests were conducted using the Compustat point-in-time database that eliminates survivorship bias.) When I sorted based on dividend growth, the portfolio's annual return came in lower, at 7.12%.

The problem, here, is that past performance is not an effective guide for helping us assess the likelihood of future dividend growth. From this same universe of income candidates, I ranked stocks each year based on rate of dividend growth. The correlations between the growth-rate rank in a particular year compared with the prior year's rank were typically 0.30-0.40 (zero meaning no relationship whatsoever and 1.00 meaning a perfect relationship). It wasn't much different when I compared successive three-year growth rates. Statistically, if we square a correlation, we wind up with a measure of the percent of causation. In other words, if the correlation between the dividend-growth-rate rank this year is correlated 0.40 with last year's rank, then you would say that last year's growth-rate rank accounted for 16% of the "cause" of this year's rank. If I skip the ranks and do regressions based on the actual growth rate numbers, the correlations and percentages of causation are about the same. So essentially, we're seeing, here, that future rates of dividend growth are about 84% or more caused by things other than the past rate. No wonder dividend growth turned out to have been so unproductive in tests of my screening strategy!

I tried a different back-door approach by sorting based on companies and stocks that seem fundamentally appealing based on the same kinds of criteria investors are accustomed to examining for stocks in general, whether or not they are seeking income. I did this through the QVG (Quality-Value-Growth) ranking system I created for StockScreen123. The idea here is that companies with good quality metrics (returns on capital, margins, finances, liquidity) are likely to have the capacity to raise dividends at a good rate in the future. Companies growing briskly would seem to similarly harbor the potential to raise dividends. And conventional value metrics seem to work quite well in the income universe (the more attractively aligned a stock is with EPS, cash flow, etc., the better the potential for a good yield based if not on future stock prices then at least on the price you pay today). Bear in mind that I'm running my QVG sort not against the stock universe as a whole but a small pre-qualified sub-set that passed the screen I ran to identify reasonable-quality yield plays. (Those who've seen my articles before may have noticed that I often use the QVGM model, which includes a momentum component. I omitted momentum here since it's less effective for income plays, especially when the rebalancing interval is stretched beyond the four-week periods I usually use.)

In sum, instead of ranking income candidates based on dividend-growth history, I ranked them based on garden-variety fundamental and value metrics. So rather than relying on a convenient and easy but ultimately ineffective way of predicting future dividend growth, I rely instead on measures that indicate the capacity to produce higher dividends in the future. This resulted in a vast improvement. The five-year annual return on the back-tested portfolio improved to 15.03%.

Here are some names appearing in the latest list that look interesting:

Microsoft (MSFT)

A year ago if anyone would have told me I'd say something nice about Microsoft I'd have said they were crazy, but what the heck: The world changes.

Amazingly at least in the eyes of a cynic who had become bored to death with the endless revisions of Windows and stretching to various enterprise endeavors, who has only barely finished laughing at Zune, and who has been rolling his eyes over the company's having recently tried to hitch its wagon to Nokia (NOK), it looks like Microsoft has finally planted a meaningful stake in the field of computer innovation. I'll say right up front I have no clue whether or not the new Surface tablet per se will amount to much, but as a prospective investor, I love the fact that MSFT has again become relevant. Even if Surface is a complete flop, it at least made for a conspicuous vehicle for bringing Windows 8, a genuinely new offering, onto center stage and more importantly, perhaps, it raised the issue of form-factor to a new level.

By now, many have learned to love tablets but when it comes to replacing laptops (something a lot of us are itching to do), many remain disappointed. Don't take my word for it; just walk into any Starbucks or comparable venue. On a business trip a few weeks ago, I really wanted to leave my netbook home but chickened out at the last minute and that was a good thing since it turned out I had to do some things that would have been a nightmare with my iPad. I'm not sure Surface is the answer, but other manufacturers are now eagerly jumping into the fray with various kinds of ultrabooks, and even that label may be too general given the way different models do with screens and keyboards. For technology bloggers, this is incredibly bullish. As an investor, I wouldn't want to gamble on Surface per se, but I'm excited about pc innovation in general and it looks like MSFT will experience something with Windows 8 that it hasn't experienced in a long time; lots of sales motivated not so much by incremental so-called improvements in hardware and/or operating system but by substantial innovation. Even if MSFT fails to become a serious player in tablets, it looks well poised to become a major player in the next generation of newfangled gizmos that use Windows 8 as they evolve toward the bridging of the gap between tablets and laptops. I suspect that the ultimate-winner device has not yet been introduced into market. But I am getting increasingly comfortable with the proposition that MSFT will benefit as device makers try one thing after another and gradually work their way to the next truly big thing.

For income seekers, this potential for new growth is accompanied by a 3.4% yield, not to mention a long-standing tendency on the part of the company, for all its R&D and capital spending, to be unable to reinvest cash as quickly as its operations have been generating it. Shares have been bought back, dividend payments have been increasing. And since the mid-2000s, dividends as a percent of cash from operations minus capital spending, have ranged for the most part between 15% and 20%.

Mattel (MAT)

When considering candidates for income investing, toy companies aren't usually top of mind for me because they inspire thoughts of hits and misses and fads and busts involving the kind of volatility income-seekers usually hate. So when I saw Mattel on the list, I sneered a bit. But its yield, 3.38% was eye-catching not so much because it was high (this was an income screen; all the stocks have yields in that range) but because it wasn't higher. If my boom-bust volatility gut reaction was right, the yield should have been at least 5%-6%. (Mr. Market is remarkably good, more so than he often gets credit for being, in establishing income-stock yields within ranges that reasonably reflect relative business risk.)

With Mattel, I think it's simply a matter of bigger (trailing 12 month sales: $6.3 billion) being better. It has a lot of toy brands: Barbie, Fisher-Price, Hot Wheels and it seems, a gazillion others. Maybe investors who live and die by how stocks behave in response to near-term earnings guidance have reason to sweat consumer preferences from one quarter to the next, but income seekers don't given the breadth and diversification of the toy portfolio. Dividends as a percent of cash from operations minus capital spending have often ranged from 35% to 40% (notwithstanding a 2010 jump to 44%), not quite as snazzy as we saw above with MSFT but still pretty darn good.

There is some concern, here, as to whether MAT is on the wrong side of technological evolution given the way play seems to be moving more toward electronic devices rather than traditional kinds of "things." That doesn't seem likely to apply to very young children (I can't imagine parents being nearly as keen as TV-commercial producers to let infants fool around with iPads and the like) but I can envision youngsters in the latter stages of childhood migrating to electronics from tangible toys. On the other hand, there is something to be said for the collectibles property of certain kinds of toys (Yikes! I should have said "action figures" and so forth), especially those tied into movies etc. (and as a big company, MAT is well positioned to pursue such deals). More importantly, though are rising living standards in many other parts of the world, a trend that seems likely to make parents in such countries more willing and able to indulge children but not enough so, at least for a couple of decades, to get them computers or tablets. Again, MAT's size should help. It seems likely to be well positioned to analyze consumer tastes elsewhere and to distribute and promote globally.

Projecting out to infinity as spreadsheet-wielding quants like to do, we may have reason to back away from MAT, which may really be over the hill by, say, 2075. But human income seekers don't need to project to infinity. For us, MAT looks fine.

Genuine Parts (GPC)

Imagine your car is in the shop for a necessary repair. It's 1975. You've got a problem. You need a particular part and the shop doesn't have it. "When will you get it," you ask. "I don't know," the mechanic answers. "I'll order it from the manufacturer and let you know when they can ship it." Fast forwarding to 2012, you need a particular part and the shop doesn't have it. "When will you get it," you ask. "I should have it in about an hour," the mechanic answers. "And you can pick up the car an hour after that."

Distribution makes a difference, a huge difference, in modern life and in the area of replacement auto parts, GPC is the big gorilla thanks to its NAPA branded distribution centers and stores. When investors think of financial engineering, they often think of such things as Modern Portfolio Theory, derivatives, etc. But capital markets aren't the only branch of finance. There's corporate finance as well and working-capital management is a big part of it and there's quite a bit of "rocket science" involved there too, and unlike a lot of Wall Street rocket science, the working-capital models, particularly just-in-time-inventory models, actually work and independent distributors handling the dirty work that manufactures don't want to bother with and which end-users are unable to handle are a big part of that.

Bottom line: GPC is in a great business that consistently generates returns on equity in the high-teens (and most recently, a tad above 20%). It may not always shine for the beat-the-guidance crowd (auto parts has its ups and downs) but for investors sitting with a 3.15% yield from a company whose annual dividend outlays as a percent of cash from operations have often been in the 35%-45% range, the business is just fine.

Looking ahead near term, we have two dynamics that help the replacement auto parts business: increases in miles driven (a cyclical phenomenon) and the aging of the vehicle fleet (the recent bad economy inhibited many consumers form buying cars and the old ones still on the road need more maintenance). A contrary dynamic is that economic improvement will enable more consumers to junk their jalopies and get something new that, hopefully, won't need as much repair in near term. The good news, in a perverse socially-repugnant Wall-Street-only frame of mind, is that many consumers still have more debt than they'd like so this auto recovery may be less pronounced than others.

Auto is not GPC's only area. Industrial Products has been doing well. If you think you're impatient waiting for a fan belt for your car, imagine a factory manager who needs to make sure he doesn't get caught at the wrong time without any bearings! As the economy improves, this part of GPC should do well as should its small electronics products distribution group. The only area that seems likely to stay sluggish is office products, where white collar employment remains lackluster.

ConAgra Foods (CAG)

I thought I was really going to like this stock and its 3.53% yield. Processed-food companies tend to be stable and good for income seekers. But then, the company announced it would pay $5 billion to acquire Ralcorp (RAH). Strategically, I think the move is great and apparently, so do many others who envision CAG riding this deal to become a powerhouse in store brands; CAG actually rose after the announcement. That's atypical. Shares of acquirers usually fall.

CAG said the acquisition would not inhibit payment of dividends, and I'm sure the company means what it says. But every acquisition starts with impressive numerical presentations in pitch books, PowerPoints, prospectuses etc., but we all know that in the real world, many face far more obstacles than are anticipated up front. This deal doesn't seem as complex as cloning sheep, so I do believe the dividend will persist. But we're looking here for companies capable of delivering strong rates of dividend growth going forward. On that issue, I need a bit more persuasion and I'm not sure anything other than a verdict from Father Time will suffice.

Again, I don't dislike CAG. But there are many other stocks that can deliver comparable yields without forcing investors to evaluate the dividend-growth uncertainties that come from the company's having made a major acquisition for cash.

Appendix

Here are the screening rules I used to identify potential equity-income candidates.

  • I focused on manufacturing firms by eliminating Royalty Trusts, MLPs and REITs, and to keep the financial statements comparable. I also eliminated firms in the Financial sector.
  • Yield must be between 3% and 7% to carve out a reasonable range of business risk.
  • Each company's trailing-12-month Payout ratio can be no more than 50% above the industry average.
  • The current relative yield (yield divided by industry average yield) must be no more than 25% above its five-year average (a big jump might signal some sort of market worry).
  • The dividend growth rate over the past three years must be positive and no worse than 75% of the industry average.
  • Passing stocks are sorted based on the QVG rating and the top 15 are selected.
Source: A Backdoor Approach To Dividend Growth