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This article was originally written in response to a request from Mick Weinsten, Editor-in-chief of Seeking Alpha, as preparation for a live panel discussion on dividend investing on 12/7/2009. We offer it here as a clarification and expansion of points we were trying to make as well as responses to questions.
1) What balance sheet factors do we look for in equity dividend investing? Does this change at different times, or according to market cycles?
When investing for dividends we start by screening for companies with a debt to equity ratio below 50%. Companies with healthy balance sheets and strong cash positions are most likely to pay and continue to pay their dividend. The balance sheet, however, is a static measurement of a company’s financial condition in present time. Therefore, we always analyze the balance sheet in conjunction with the income statement and statement of cash flows.
Our objective is to evaluate a company’s dynamic ability to cover its dividend; past, present and future.
At EDMP, Inc. we believe in investing with a total return objective. Ultimately, with dividend paying companies, we seek companies that we believe can grow earnings at a high average or above average rates. Our objective is to generate capital appreciation in conjunction with an increasing dividend income stream. In short, we feel our clients deserve a raise in pay each year from their dividend paying holdings. We call this Growth Yield.
Consequently, the rate of change, or velocity of earnings growth, is of great interest to us. Dividends are paid out of earnings, expressed as a payout ratio. Our research suggests that mature companies tend to maintain a consistent pay-out ratio over long periods of time. Therefore, the dividend growth rate also tends to correlate to the growth rate of earnings as well. The velocity of earnings growth allows us to calculate how much time it will take to double the dividend.
We designed our Fundamentals-at-a-Glance research tool to automatically analyze and calculate these important relationships and the results they generate.
In Figure 1 below we show the historical earnings correlated chart for Johnson & Johnson (NYSE:JNJ) since 1991 which is as far back as our data allows. From this example you can see that Johnson & Johnson has consistently grown earnings at 12.6% per annum. The bottom of the graph lists dividends paid (yellow shading). Note that we only list every other year due to space constraints. The point is that dividend growth followed earnings growth. Detailed dividend figures are listed and highlighted in Figure 3. (Click charts to enlarge)
Fig. 1. JNJ Correlation of EPS Growth and Stock Price
Fig. 1. JNJ Correlation of EPS Growth and Stock Price
In Figure 2 we show Bristol-Myers Squibb Co., (NYSE:BMY) as contrast. Note the higher current dividend yield of 5% as compared to JNJ’s 3.1%. Bristol-Myers Squibb’s less consistent earnings growth of 5% per annum, translates into a much slower rate of dividend increase (yellow shading). Detailed dividend figures are listed and highlighted in Figure 4.
Fig 2. BMY Correlation of EPS Growth and Stock Price
Fig 2 BMY Correlation of EPS Growth and Stock Price
Figures 3 & 4 below show the performance that correlates to Figures 1 & 2. Note how Johnson & Johnson starts out in 1991 with a 2.1% yield (Figure 3) compared to Bristol-Myers Squibb’s higher 3.6% starting yield (Figure 4). Also notice how Johnson & Johnson’s much faster growth ultimately generated not only a larger total period dividend income stream, but a significantly higher yield in the later years as well.
This illuminates the power of the growth yield concept. Most importantly, the total return differential, assuming dividends are spent not reinvested, is large as well. The faster growing Johnson & Johnson’s 12.1% total return is more than double Bristol-Myers Squibb’s 5.1%.
Fig. 3. JNJ Dividend and Price Performance
Fig. 3. JNJ Dividend and Price Performance
Fig. 4. BMY Dividend and Price Performance
Fig. 4. BMY Dividend and Price Performance
The quality of the earnings calculations we make are highly dependent on the balance sheet and the income statement and statement of cash flows. As the old Wall Street saying goes – earnings are optional, but cash is king. Therefore, we place great emphasis on cash flow per share exceeding earnings per share. This gives us confidence that the quality of the earnings, that dividends are being paid out of, are high. We apply these standards universally across all market conditions or cycles. In short, we are making decisions based on the return realities that the cash flows generate. No considerations as to what the market may or may not do are included.
2) How do we see the role of dividend investing within a broader portfolio-building strategy?
AT EDMP, Inc. we offer two primary investing strategies that will include dividend paying companies. The first is our Large-cap Growth Strategy. Under this strategy we have a total return objective of 15-20% per annum. If a company does not pay a dividend then it must grow earnings at a historical and forecast growth rate of 15% or higher. Dividend paying companies must possess an earnings growth of 8-12% or higher and offer a starting yield of at least 1.5% for earnings growth above 10%, and 2.5% or higher yield for growth between 8-10%.
From the combination of appreciation based on earnings growth, coupled with a growing dividend yield we expect to meet our 15-20% return objective over a market cycle (at least 3-5 years) from these above average dividend payers. Additionally they provide a source of income that can be used for buy-downs and tend to be more stable price-wise than pure growth stocks. We believe this provides balance, flexibility and a level of risk reduction to the portfolio without sacrificing return.
Our second strategy is our Growth and Income strategy. Under this approach we endeavor to blend higher growth with lower starting yields with slower growing higher starting yields. We feel this enables us to provide the client that needs current income the opportunity to enjoy a growing yield and moderate capital appreciation.
Current income needs are weighted against future growth. This will determine the precise blend of higher yield with lower growth to lower yielding higher growing companies. There is an unavoidable trade-off and inverse relationship between growth and income. The more growth you seek the lower yield you can expect. However, over long time periods a faster grower with yield can possibly generate more total income.
3) What particular opportunities do we see for dividend investors in the current market – i.e., what are our current highest conviction dividend investing picks?
We believe the current stock market environment has created a rare window of opportunity for the prudent investor seeking growth and income. Even as the stock market has recovered from recession-driven lows, many of our blue-chip companies have been mostly left behind. Consequently, they are currently trading at lower valuations than we have seen over the past two decades and, therefore, offer starting yields higher than normal.
Therefore, they offer an opportunity for higher than customary returns. First, there is the arbitrage that is possible from their return to historically normal valuations. This ranges from as little as a 10% gain by merely returning to normal levels, to as much as a 100% gain. The following three examples utilizing our Fundamentals-at-a-Glance research tool illustrates the arbitrage. With each example, notice how the respective company has rarely to never traded below their earnings justified value line (green line with white triangles).
Fig. 5. MCD Correlation of EPS Growth and Stock Price
Fig. 5. MCD Correlation of EPS Growth and Stock Price
Fig. 6. CLX Correlation of EPS Growth and Stock Price
Fig. 6. CLX Correlation of EPS Growth and Stock Price
Fig. 7. AFL Correlation of EPS Growth and Stock Price
Fig. 7. AFL Correlation of EPS Growth and Stock Price
In addition to this anomalous valuation, these companies have long histories of increasing their dividends at above average rates. Finally due to their lower-than-normal valuations, current yield is higher than normal as well. Additional companies that have these rare opportunities are:
  1. McCormick & Company Inc. (NYSE:MKC)
  2. Proctor & Gamble (NYSE:PG)
  3. Hudson City Bancorp, Inc. (NASDAQ:HCBK)
  4. Kimberly Clark (NYSE:KMB)
  5. Pfizer (NYSE:PFE)
  6. Merck (NYSE:MRK)
Although these are not the highest yielding dividend payers available, we believe they offer a unique blend of growth, increasing income and safety that is rarely found. These high-quality multi-national stalwarts offer a window of opportunity that could close very quickly. However, even under normal times, these companies have historically rewarded shareholders with above market returns.
Disclosure: Long AFL, CLX, HCBK, JNJ, KMB, MCD, PG at time of writing.