Conservative Dividend Investors Have 3 Options Right Now

by: Tim McAleenan Jr.

For conservative dividend investors looking to make investments today, there are probably some internal deliberations about which stock to choose due to the valuations in the market at this time. In the current market, you have to choose between finding a "margin of safety" either in the underlying business models or finding your margin of safety in the "price" of a stock that may not have the best-in-breed dependable earnings quality that you desire.

First, let's talk about "margin of safety" in terms of business model. When I make an investment with long-term intentions, I would ideally want to own the kinds of stocks with business models that are built to stand the test of time. That means companies like high-quality utilities, consumer staples, select large-cap healthcare companies, and certain conglomerates with limited exposure to the financial sector. Those are the ideal "core stocks" of a buy-and-hold dividend portfolio.

Although these companies deliver the kind of operational business results that can be fairly characterized as "excellent", it is reasonably likely that new investors will not be able to share in the earnings growth as much as they'd like. For instance, we all know Coca-Cola (NYSE:KO) is an excellent company. You don't need me to preach about their excellent moat, fantastic returns on shareholder equity, and great long-term record of volume growth.

But here's the catch: even though the company has managed to grow earnings at slightly over 9% during the past eleven years, investors have only achieved total returns (this includes dividends paid out) of slightly below 7%. What explains this 2% shortfall? Overpaying for Coca-Cola stock. With the company now trading at 22x earnings, it should not be surprising if current investors achieved returns that slightly lagged the earnings growth of the company over the next five to ten years.

The good news, though, is that Coca-Cola's dividend has smoothly climbed from $0.40 per share in 2002 to $1.12 today. Every February, you know that the Coca-Cola Board of Directors is going to raise the dividend. It's usually a dividend raise that is 3-4% above the current inflation. There aren't many guaranteed annual raises in life, and Coca-Cola is one of the best sources that investors can find to achieve that income objective.

Still, my ideal situation is to buy a high quality blue-chip that comes with a margin of safety attached in case earnings do not work out quite as planned. In this case, I'll use Kimberly-Clark (NYSE:KMB) as an example. The company sells iconic personal care products like Kleenex, Huggies, Pull-Ups, and so on. The earnings quality of an enterprise like that is fantastic. But the past eleven years have been rough for the company from an earnings growth perspective. Earnings have only grown by 3-4% (dividends have grown by 9-10% as the company has increased its payout ratio).

But here's the nice thing: even though Kimberly-Clark has only grown earnings by 3-4% annually since 2002, investors have achieved 8% total returns since then. How is this possible? Kimberly-Clark traded below 16x earnings in 2002, and this "margin of safety" has allowed investors to achieve total returns that are much better than the growth of the firm because the valuation has shifted from 16x earnings to 22x earnings. This is why Graham was all about margin of safety. Kimberly-Clark may have had a rough eleven years on the earnings growth front, but 2002 investors got much nicer total returns because their purchase point incorporated a margin of safety.

This is why I'd be hesitant to recommend a lot of consumer staples right now. When you look at the valuations of PepsiCo (NYSE:PEP), Colgate-Palmolive (NYSE:CL), Hershey (NYSE:HSY), Aqua America (NYSE:WTR), and The Southern Company (NYSE:SO), you will see that each company is trading at a premium valuation relative to where it has traded during the 2003-2013 stretch. For investors that desire a margin of safety, that's bad news. It's one thing to pay fair value and effectively say, "I'll accept returns in line with the growth of the firm." But now, investors in companies like Hershey are effectively saying, "Over the next five to ten years, I'm willing to accept total returns that lag the growth of the firm." I don't like entering an investment with that kind of expectation. As my late uncle would say, "That just doesn't jive."

The alternative for an investor seeking a margin of safety (based on price) would be to enter the more volatile industries of commodities, financials, and tech companies because they seem to offer more value at current prices. If you wanted to do it right by going with the best in class companies in those sectors, that would mean looking at companies like Exxon (NYSE:XOM), Chevron (NYSE:CVX), Wells Fargo (NYSE:WFC), US Bancorp (NYSE:USB), and IBM (NYSE:IBM).

IBM is decently undervalued by traditional P/E metrics and is projected to grow earnings by 8.5%-10.5% over the next five years. Both Wells Fargo and US Bancorp should provide very nice dividend growth increases over the coming five years as the companies continue to grow earnings and increase their payout ratios simultaneously. Provided there is no significant decline in oil prices on the horizon, both Exxon and Chevron should grant investors earnings and dividend growth of 8-11% annually over the next five years, and they are trading at valuations that will allow investors to reap full total returns in line with the growth of the firm.

If I were looking to add stocks to my dividend portfolio at this time, I would break down my thought process into one of three options:

1. The first option is to insist on a margin of safety with those "forever" stocks that grow earnings every year like Coca-Cola and Colgate-Palmolive. If you reach the conclusion that you want to build a portfolio of consumer staples, utilities, and large-cap healthcare stocks at prices that incorporate a margin of safety, then you should probably sit on cash right now.

A lot of times, this option is derided. I remember mentioning to someone on Seeking Alpha that I thought Procter & Gamble was worth somewhere around $76 per share, and I remember receiving a message from a Seeking Alpha reader calling me unrealistic for thinking that Procter & Gamble would fall that low. The funny thing, of course, is that Procter & Gamble has traded as low as $59 in the past twelve months.

In rising markets, it's easy to believe that you'll never get your price again. Personally, I don't think you should ever feel a need to "force" an investment. Coca-Cola will trade below 18x earnings again. Colgate-Palmolive will trade below 18x earnings. And yes, even Hershey will trade below 18x earnings. It's all happened before. The difficulty of holding cash is that it involves (1) potentially missing out while others enjoy larger gains, (2) missing the dividend income you could be generating, and (3) it can be frustrating to delay the desire to own productive assets and "put your money to work."

2. The second option involves buying the consumer staples, utilities, and other building portfolio building blocks even with the knowledge that the total returns generated will likely trail the overall growth of the firms over the medium term.

The advantage of this approach is that it allows you to own the highest quality assets in the country. This is an advantage that is easy to underestimate. But when you own Coca-Cola, PepsiCo, and Colgate-Palmolive, you know that you are going to get that dividend increase every year. You can be reasonably assured that earnings will go up nine years out of ten. It can be a lot of fun knowing that you own a "dividend machine" that will spit out more and more money each year.

Another advantage is that the consequences of modestly overpaying become minimal if you have a time horizon greater than twenty-five years. When you stretch out the time frame, it does not matter as much if you overpaid a little bit. Whether you paid 25x earnings for Colgate in 1972 or 16x earnings for Colgate in 1973, it doesn't matter all that much-you'd have a heck of a lot of money today.

The big question is whether putting yourself in a situation where you have a modestly "negative" margin of safety over the next five to ten years is worth it.

3. The third option is to buy certain banks, tech stocks, and oil companies. The advantage here is that you get attractive prices. It's likely that if you buy Exxon, IBM, and Wells Fargo at today's price, you will receive total returns that slightly outstrip the earnings growth of the companies. That's the advantage of buying stocks with a margin of safety.

Likewise, all three companies mentioned above are currently delivering high dividend growth rates to investors, and this should continue for the next five years barring some kind of severe economic collapse.

The potentially unappealing thing about this approach is that it forces investors to potentially deal with volatile earnings. Exxon has a fantastic dividend record, but if oil falls materially, Exxon's earnings can fall in a hurry as well. That kind of earnings volatility may bother some investors during troubled economic times. Likewise, the debt to equity involved with bank investments automatically means that you must devote a few hours each month to studying the balance sheet of your holdings in the sector.

Anyway, if I were a dividend growth investor trying to make an investment today, I'd break it all down to those three options. If I wanted to own non-cyclical Dividend Aristocrats in industries with very stable earnings, I'd probably stay in cash for a while. If I were willing to accept the possibility of total returns that lagged the growth of the businesses, I'd go ahead and buy something like Coca-Cola and PepsiCo with the tradeoff that I am acquiring some of the most dependable sources of long-term income growth in the world. And if I wanted to begin investing now in companies that offer a margin of safety at current prices, I'd look to the best oil companies, best banks, and best tech companies. It's up to you to choose the path most compatible with your temperament, risk tolerance, and long-term goals.

Disclosure: I am long XOM, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.