The article explores some lesser known stocks for investors focused on dividend growth.
The key guiding principle I had in mind was to focus on businesses with strong economic moats and high barriers to entry. A business with defensible barriers to entry is invaluable. It's what creates the ability for the company to generate consistent earning growth over a long period of time. I'm after a business whose dividends can grow for years into the future, rather than those whose dividend growth may be peaking at present.
I've picked criterion that focus on revenue growth (to indicate rising demand for the product or service), operating cash flow growth (to indicate cash production and ability to pay dividends) dividend yield, dividend growth and payout ratio.
1. Revenue growth exceeding 5% per annum over the last 5 years. Revenue growth is what drives a business. Without it, you don't have much chance of consistently increasing profits and getting increasing dividends.
2. Operating cash flow growth exceeding 5% per annum over the last 5 years - I prefer cash flow measures to earnings, and I view operating cash flow as the cash generated by the company's normal business operations. Cash flow is the lifeline of a business. Without operating cash flow and cash flow growth, a business will struggle to consistently raise dividends over an extended period of time.
3. Dividend yield of at least 2.5% - To build a sustainable dividend stream over a prolonged period of time you need a reasonable initial dividend. High growth on a very low dividend base will take years to build sizeable dividend income.
4. Compounded dividend growth exceeding 5% per annum over the last 5 years - A growing dividend stream will not only help you generate a growing stream of passive dividend income, it should lead to a sustained increase in wealth over time. At a minimum, dividends should exceed inflation otherwise the purchasing power of your income stream will decline.
5. Payout Ratio - A business should not be paying out more than 80% of its earnings per share on dividends. An upwardly trending payout ratio exceeding 80% could be a sign that the business may struggle with future dividend growth.
I'm going to introduce a selection of less well known companies for consideration as dividend growth candidates.
Data used was for 2006-2011 period unless otherwise indicated. Growth rates provided are annualized for the period indicated. Data referenced from morningstar.com.
CME Group (CME) - CME Group operates a number of futures and options exchanges. Products traded on these exchanges include interest rates, foreign exchange, energy, equity indexes and commodities. Founded in 1898, CME group is a $20B company, with gross margins of 80%. CME group has a significant economic moat as a result of the large liquidity and volume for products traded on its exchanges. In many cases, this gives rise to better price discovery than is available on competitive exchanges and attracts traders to the CME Group.
CME Group has achieved revenue growth of 17% per annum over the last 4 years. Its operating cash flow has grown at a healthy 13% per annum, while its dividend growth rate has also been a good 13% per annum over this period. With a payout ratio of only 20% as of 2011 and a dividend yield of around 3.1%, CME Group scores 5 out of 5 stars. (2006 data was excluded for CME to remove the effects of Chicago Board of Trade acquisition)
Automatic Data Processing (ADP) - Automatic Data Processing provides a range of outsourced services for payroll, time management and tax administration. Founded in 1950, Automatic Data Processing is a $30B company with revenues close to $11B and gross margins around 40%. The payroll services provided by Automatic Data Processing have significant switching costs. Once payroll services are deployed they become difficult to replace. This gives rise to an economic moat for Automatic Data Processing.
Automatic Data Processing has achieved revenue growth of around 6.5% per annum over the last 5 years. Operating cash flow growth has been a healthy 8% per annum, while dividend growth over the period has been a good 12% per annum. With a current payout ratio of around 55% Automatic Data Processing still has plenty of scope to increase its dividend. Trading on a current yield of about 2.7%, Automatic Data Processing scores well across all dimensions with 5 out of 5 stars.
CSX Corp (CSX) - CSX Corp offers rail transportation services across the US. It transports a diverse range of consumer and food products as well as commodities. Founded in 1978, CSX is a $23B company with revenues of $12B and gross margin close to 70%. CSX has an economic moat which results from ownership of rail track infrastructure which is difficult to replicate without relevant approvals and significant capital investment.
CSX has achieved modest revenue growth over the last 5 years of just over 4 % per annum. Its operating cash flow has grown at a good 11% per annum while its dividend growth rate has been an impressive 27% per annum. CSX has a very modest dividend payout ratio of 25%. At this level, CSX has great flexibility to increase its dividend going forward. CSX is sitting on a current yield of approximately 2.5%. CSX scores 4 out of 5 stars.
Sysco Corporation (SYY) - Sysco is involved in the marketing and distribution of food and food services products to restaurants and food service providers. Founded in 1969, Sysco is a $19B business with revenues of $43B and gross margin of around 20%. Sysco has a large distribution network, allowing it to leverage economies of scale in servicing its clients at much lower cost than its competitors.
Sysco has achieved low revenue growth of 3.1 % per annum over the last 5 years. Its operating cash flow has been flat over a 5 year period while its dividend has increased by a reasonable 7.5% per annum. With a payout ratio of close to 57%, Sysco has good scope to increase its dividend. With a current yield of 3.5%, Sysco scores 3 out of 5 stars.
Visa Inc (V) - While a well known company, Visa is not traditionally thought of as a dividend growth stock due to its relatively small yield. A dominant player in the credit card network oligopoly, Visa is a $127B company with revenues in excess of $10B and gross margins of close to 80%. Visa has significant network effects due to the technology and marketing costs associated with creating a processing network and gaining consumer and merchant acceptance.
Visa has achieved revenue growth of 13 % per annum over the last 4 years. Its operating cash flow has grown at 75% per annum while its dividend growth rate has been a good 27% per annum over the last 3 years. With a payout ratio of close to 40%, Visa has plenty of scope to further increase its dividend. Trading on a current yield of 0.8%, Visa scores 4 out of 5 stars.
For those with a longer term time horizon, Visa offers significant growth potential from its exposure to emerging markets as well as trends in Mobile POS acceptance. Both should significantly accelerate revenues and drive future dividend growth.
Of the 5 stocks that we looked at CME Group, Automatic Data Processing and CSX Corp all appear to be stand outs as far as meeting growth metrics across a range of revenue, cash flow and dividend measures. Each warrants further consideration as a possible addition to a dividend portfolio.
Visa, which has a low current yield, may offer significant long term dividend growth potential for investors. Sysco requires additional due diligence to determine whether it may be able to generate sustained dividend growth going forward.
In all cases, the stocks above represent some possibilities to consider for a dividend portfolio, subject to more detailed analysis and determination of what a suitable entry point into the stock may be.