A lot of times, the "subjective" stuff that involves personal judgment calls gets short shrift during investment discussions because opinions, editorial remarks, and guessing do not carry the weight of the hard numbers. The problem with this approach, though, is that many areas of finance that are slippery to quantify are important to investors, and often get shortchanged in investing discussions because the topic relies more on art than science.
Today, I want to talk about one of the investing areas that is particularly hard to define: the concept of a "dividend culture." A lot of times, we hear the advice to look for companies with "good management" when considering an investment, but there's little criteria out there by which we can judge whether our companies have good leadership (in fact, we often reverse the process and look for signals of bad management such as excessive compensation that is highly dilutive to shareholders, and often consider companies that are not engaging in anything obviously bad to be "good management").
But I wanted to share with you the two-step process I use to determine whether a company likely has a "dividend culture" that should provide investors with dividend increases over the next five to ten years, based on present known factors.
When thinking in terms of dividend cultures, the first thing I do is weed out companies with less than twenty years of dividend increases. Sure, there are some companies out there like Dr. Pepper (DPS) and Philip Morris International (PM) that seem poised to have long winning streaks ahead, but I am more interested in creating a filter screen that only includes companies with dividend cultures, even if that means leaving out a few companies that would be promising candidates when analyzed on their individual merits.
And, of course, the twenty-year cutoff point is a subjective assessment (I could have easily chosen 19 years or 21 years), but the point is this, I want to find businesses that have long-term business models that thrived through different business cycles. I don't want to find the businesses that are merely riding a fortunate tailwind that have allowed them to put together a good streak through the 2000s.
In baseball, you don't start thinking that a pitcher is going to throw a no-hitter just because he got through the first inning or two without giving up a hit. You'd probably wait until the fifth inning or so before those thoughts start to cross your mind. Likewise, I do not think that a company has a "dividend culture" until it has been raising the dividend payout annually for at least two decades.
The next filter in my screening is earnings per share growth. If the company is not increasing profits, you can't keep any kind of streak intact. For example, before the recent dividend cut, Pitney Bowes (PBI) had been raising its dividend since 1983. However, the company has experienced earnings declines of 0.5% per year for the past ten years. When your earnings are going down every year, even if it is only by a small amount, it is almost impossible to maintain a "dividend culture." At the end of the day, a "dividend culture" is only as strong as the growth of the underlying business. In many cases, I like to see an earnings growth rate of at least 5% annually (at a minimum) over the past ten years before I will consider investment (I picked 5% as the minimum cutoff point because I wanted to make sure that the earnings growth and dividend growth was able to increase at a rate above the 3-4% inflation rate that has historically been the average in the United States).
For investors interested in doing a quick screen of eligible stocks with powerhouse histories of raising dividends, I would suggest a process like the following.
First, we'll take a quick look at a company like 3M(MMM), which has been raising dividends for 55 years straight. When you look at the company's ten-year history, you will see that the company has been raising dividends by 6.0% annually for the past ten years while growing earnings annually by 10.0% over the past decade. That's a company worthy of further examination because it passes both hurdles.
Next, we'll look at American States Water (AWR), which has been raising dividends for 58 years. The company has been growing earnings by 6.5% and raising dividends by 3.5% over the past decade. The dividend raises have been too small, and we'll eliminate American States Water from consideration on our list.
Now we'll check out Cincinnati Financial (CINF), an insurance company that has been raising dividends for 52 years. The company has been growing dividends by 8.5% annually while growing earnings at only 2.0% over the past decade. That earnings growth rate is way too low, and we'll remove Cincinnati Financial from our "due diligence" list.
Allright, now we'll take a look at dividend darling Coca-Cola (KO), which has been raising dividends for 51 years. The softdrink giant has been growing earnings by 9.0% and dividends by 10.0% over the past decade. That's certainly worthy of further consideration based on our metrics.
Next up, we'll look at the record of Colgate-Palmolive (CL), which has been raising dividends for over 50 years and paying out dividends since the sport of volleyball was invented by W.G. Morgan in 1895 (yes, Colgate started paying out dividends about a month before the first volleyball net was set up). Colgate has been growing earnings by about 9.5% annually over the past decade (and raising dividends by 12.5% over that time frame), so I think it is safe to say that Colgate is worthy of further consideration based on these metrics.
Now we'll take a look at Diebold (DBD), which has been raising dividends for 60 years straight. Dividends have grown by 5.5% annually over the past ten years, but earnings have only grown by 0.5% annually. That company will be removed from our list. Honestly, we're investors in an economy worth trillions of dollars, and we have over 15,000 different stocks to choose from, and there is no need to limit ourselves to a company that hasn't even found a way to grow earnings by 1% annually since 2003.
The next company in line is Dover (DOV). The company has grown earnings by 6.5%, and dividends by 8.5% over the past decade. That company can stay on our list.
And now it's about time we got to a company that I actually own: Emerson Electric (EMR). The industrial heavyweight has been raising its dividend for 56 straight years, and the dividend has grown by 7.5% annually over the past ten years while earnings have grown by 6.5%. It also the added bonus of being headquartered right next to where my dad grew up (anytime you can add personal enjoyment to the wealth creation process, go for it). That company is certainly staying on the list.
And lastly, we'll take a look at Johnson & Johnson (JNJ). The healthcare supergiant has been raising dividends for 51 years, and the earnings have grown by 11.0% over the past decade while dividends have grown by 13.0%. Along with Colgate, that's the most impressive showing we've seen so far. Johnson & Johnson is certainly worthy of future investigation.
I just applied my earnings and dividends requirements to most companies with dividend growth streaks spanning more than half a century. There is no hard rule for what defines a "dividend culture", but you can make a lot of headway towards finding companies with "dividend cultures" if you make a general list of all companies that have been raising dividends for at least twenty years, and then narrow your list from there to the companies that have been growing earnings and dividends by at least 5% annually over the past decade. The "dividend culture" of a company's management team ultimately depends both on the company's history and sustained growth, and if you apply a filter like I did that screens companies for both metrics simultaneously, you can put yourself in a very strong position to own companies that are likely to grow dividends every year for the next decade and beyond.