Dissecting Dow 11,000: How Much Do Dividends Really Matter? (Part 2)

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Includes: AXP, BA, DIA, GE, HPQ, JNJ, JPM, MCD, MMM, PFE, PG
by: Chuck Carnevale

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Dividends provide many benefits to prudent long-term investors. However, it’s implicit that in order to reap the best of the benefits from dividends you have to position yourself as a true investor. For the most part, dividends are paid quarterly. Furthermore, it is our view that the best dividend generators have a legacy of increasing their dividends each year. In short, you have to own a company for long periods of time to maximize the contribution dividends provide. Day traders don’t own a stock (company) long enough for dividends to make a difference.

Mark Twain once said: “I am more concerned about the return of my money than the return on my money.” The return of capital is one of the best benefits of owning dividend paying stocks. In effect each time a dividend is paid your risk is reduced because you now have less capital at risk. Getting a raise in pay each time the company increases its dividend is another great feature.

However, it’s also important to keep in mind that dividends come directly from earnings. Therefore, we argue that dividends are an effect of returns, rather than a cause of returns. In other words, since earnings are the source of dividends, it is earnings that cause both dividends and long-term returns.

Part 2: Second-Ten of Dow 30 Best Performers

In Part 2 of our three-part series, we will feature the second-ten best performers of the Dow Jones Industrial Average since 1996. Four of these mid-ten Dow 30 stocks have earnings growth over 10% (PG, JNJ, MCD, and PFE). Three more have earnings growth above 7% (MMM, HPQ, BA), leaving only three with earnings growth below 7% (AXP, JPM, GE). Even though all ten pay a dividend, their equal weighted average yield at 1.85% is the lowest of the three sets of 10 companies.

Figure 1 below provides an overview of the second ten or mid-ten best performing Dow 30 stocks since 1996. They are listed in order of highest total return to lowest. You should note that Pfizer with the highest current yield came in eighth out of ten.

Figure 1: Second Ten of Dow 30 – Ranked by 15yr Performance as of 4/12/2010 Figure 1: Second Ten of Dow 30 – Ranked by 15yr Performance as of 4/12/2010 (click to enlarge)Click to enlarge(click to enlarge)

Figures 2a & b through 11a & b look at the second ten of the best performing Dow stocks since 1996 through the lens of our F.A.S.T. Graphs™. There are three different iterations of this tool designed to assist in calculating intrinsic value based on earnings. Each of these iterations is dependent upon the Earnings Growth Rate number, printed in green, to the right of each graph.

For companies growing earnings at 15% or better, the graph is a PEG ratio (Price/Earnings equal to Growth Rate) calculation for value. For companies growing earnings at 5% or less, the graph uses Ben Graham’s formula for value. These graphs are marked in orange ink with – GDF – then a number that represents the value P/E ratio. For companies growing earnings between 5% and 15%, the graphs use a modified version of the first two and are marked in orange ink– GDF-EDMP – then the number representing the calculated value P/E ratio.

Therefore, the green line with white triangles represents fair value for each respective company. In other words, when the black line touches the green line, the stock is theoretically in value. Prices above the fair value line indicate over-valuation and prices below the fair value line indicate under-valuation.

Keep in mind that fair value does not necessarily imply high return. Slow earnings growers, even bought in value, will often generate lower returns than faster growing companies bought in value. However, and most importantly, notice how price and earnings correlate on each graph over time.

Figure 2a & b: Procter & Gamble Co. (NYSE:PG)

Procter & Gamble became one of our core holdings after its price (the black line) fell below its True Worth™ earnings justified value line (green line with white triangles). Notice how strong the correlation between earnings and market price is for this stalwart. Anytime the price deviated from earnings it inevitably returned. Also as seen in 2b, strong earnings growth has led to an unbroken record of raising dividends since 1996.

Figure 2a: PG 15yr EPS Growth Correlated to Price Figure 2a: PG 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 2b: PG 15yr Dividend and Price Performance Figure 2b: PG 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 3a & b: Johnson & Johnson (NYSE:JNJ)

Johnson & Johnson also became one of our core holdings after its price (the black line) fell below its True Worth™ earnings justified value line (green line with white triangles). As with Procter & Gamble, even if you would have purchased JNJ when it was modestly overvalued at the beginning of 1996, strong earnings growth allowed you to outperform the market on a capital appreciation basis. Add in its growing dividend each year and total return becomes quite attractive for this blue chip.

Figure 3a: JNJ 15yr EPS Growth Correlated to Price Figure 3a: JNJ 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 3b: JNJ 15yr Dividend and Price Performance Figure 3b: JNJ 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 4a & b: American Express Co. (NYSE:AXP)

American Express illustrates the importance of earnings from a perspective quite different from our first two examples. From Figure 4a, it is clear that stock price followed earnings as they were rising and then fell abruptly with earnings that also fell abruptly. Over time, whether moving up, down, or sideways, price follows earnings.

Figure 4a: AXP 15yr EPS Growth Correlated to Price Figure 4a: AXP 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 4b: AXP 15yr Dividend and Price Performance Figure 4b: AXP 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 5a & b: 3M Co. (NYSE:MMM)

3M is another example of a high quality dividend paying stalwart that only recently experienced a stock valuation that is historically on the low side. However, 3M has an excellent history of increasing its dividends in line with its earnings growth. The importance of dividends are clearly seen in this example as they added 1.8% to the total annualized rate of return.

Figure 5a: MMM 15yr EPS Growth Correlated to Price Figure 5a: MMM 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 5b: MMM 15yr Dividend and Price Performance Figure 5b: MMM 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 6a & b: McDonald’s Corp. (NYSE:MCD)

McDonald's has morphed from more of a growth stock from 1996 through 2002, whereupon its payout ratio grew it into more of a growth-and-income stock. Therefore, in the future, McDonald's dividend will play a more prominent role.

Figure 6a: MCD 15yr EPS Growth Correlated to Price Figure 6a: MCD 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 6b: MCD 15yr Dividend and Price Performance Figure 6b: MCD 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 7a & b: JP Morgan Chase & Co. (NYSE:JPM)

For a diversified financial services firm, JPM has a very cyclical history of earnings performance. In Figure 7a, notice how stock prices follow earnings up for the first four years, then follow earnings down for the next four years, then up again, and finally down during the recession. It is only thanks to a low earnings justified valuation in the beginning of the period and to a high earnings justified valuation at the end, that allowed returns to be respectable from such a slow grower. Most importantly, notice how the collapse in earnings during the recession caused a more than 65% cut in their dividend. Earnings are the source of dividends.

Figure 7a: JPM 15yr EPS Growth Correlated to Price Figure 7a: JPM 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 7b: JPM 15yr Dividend and Price Performance Figure 7b: JPM 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 8a & b: Hewlett-Packard Co (NYSE:HPQ)

Hewlett-Packard also illustrates the importance of earnings. When earnings dropped precipitously in 2001 and 2002, stock price, perched at lofty valuation, was vulnerable to a massive correction. However, as earnings began to recover, in 2003 and beyond, stock price once again tracked earnings to the upside. In this example that we classify as a growth stock, the impact of dividends, although minimal, nevertheless sweetens the pot a little.

Figure 8a: HPQ 15yr EPS Growth Correlated to Price Figure 8a: HPQ 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 8b: HPQ 15yr Dividend and Price Performance Figure 8b: HPQ 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 9a & b: Pfizer, Inc. (NYSE:PFE)

Pfizer, once a strong and consistent growth story, has seen their earnings become more cyclical in recent times. Therefore, what was once a long string of rapidly increasing dividends was broken in 2000 when earnings fell and again in 2009 for the same reason. Earnings determine market price and dividend income.

Figure 9a: PFE 15yr EPS Growth Correlated to Price Figure 9a: PFE 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 9b: PFE 15yr Dividend and Price Performance Figure 9b: PFE 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 10a & b: General Electric Co. (NYSE:GE)

Once the darling of Wall Street, a large financial division decimated General Electric's normally consistent earnings growth. Note how stock price followed earnings down, therefore during this fourteen plus year period, the rate of change of earnings growth and shareholder capital appreciation closely correlated at 3% and 2.7% respectively. Also, a drop in earnings led to a dividend cut in 2009 as well. Once again, evidence to the importance of earnings.

Figure 10a: GE 15yr EPS Growth Correlated to Price Figure 10a: GE 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 10b: GE 15yr Dividend and Price Performance Figure 10b: GE 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Figure 11a & b: Boeing Co. (NYSE:BA)

Boeing is clearly the most cyclical stock in our list of the second ten Dow 30 best performing stocks. Here the importance of earnings are depicted in a different manner. Inconsistent earnings growth caused dividends to remain the same from the period 1997 to 2000 and once again for the period 2001 to 2003. Although Boeing has not cut their dividend during this fourteen plus year period, predictability of what next years dividend may be is suspect.

Figure 11a: BA 15yr EPS Growth Correlated to Price Figure 11a: BA 15yr EPS Growth Correlated to Price (click to enlarge)Click to enlarge(click to enlarge)

Figure 11b: BA 15yr Dividend and Price Performance Figure 11b: BA 15yr Dividend and Price Performance (click to enlarge) Click to enlarge(click to enlarge)

Conclusion

With slower earnings growth, dividends became a much more important source of total return for this second group of ten companies, than it was for the top ten group. So there is no denying that dividends are a very important component of investor total returns. However nothing we have seen thus far would indicate that higher yielding companies generate higher rates of return over time. One of the real advantages of dissecting the Dow 30 Industrial Average is that the index is small enough to be reviewed in detail. Therefore, rather than relying on inferences and/or the statistical generalities, we can analyze the facts. So far, the facts are speaking loudly.

In part 3, we will review the final ten (bottom ten) performers of the Dow 30. As a prelude to what you will see in part 3, the remaining ten companies we will review have the highest current yield, the lowest earnings growth, and the lowest total return of all three groups.

Disclosure: Long PG, JNJ, MCD, HPQ at the time of writing