Finding Alpha With Dividend Growth: The Stocks

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Includes: VIG
by: Dale Roberts

Summary

In the accumulation phase, total return is the most important metric, with strategy matched to your risk tolerance level of course.

Studies suggest that low payout ratios are the signal that market beating total return is on the way.

I've consulted with some market beaters to see what low payout ratio companies are in their portfolios.

In a recent article here, I outlined how the magic of dividend growth for those who seek to outperform the market is the combination of high yield or low yield and a low payout ratio according to a study by Credit Suisse. Here's the chart that neatly summarizes the potential of dividend growers and initiators to beat the market.

Click to enlarge

And here's the Credit Suisse chart showing that low payout ratio phenomenon.

Click to enlarge

Certainly many studies show that dividend and dividend growth stocks have the potential to outperform. That said, how do dividend growth stocks achieve that historical outperformance?

There are certainly a few drivers of total return. At the root of it all is a company that is growing its revenue and earnings. Given that, whether a company pays a dividend or not is a moot point. But investors love dividends, and investors will reward a company that continually pays a dividend and continually increases those dividends. That love will turn in to higher share prices, and share prices that can also offer less volatility or risk.

Not only that, a rising dividend history is evidence of a company that has the ability to grow its business and support that growing dividend. I thought Seeking Alpha commenter EK1949 offered a wonderful analogy with this skillful collection of words. I am a sucker most anything with a Darwinian slant.

Since dividends are both evidence of competence and the results of it, where else do we see similar phenomena? We see it in nature. Nature is wasteful and extravagant in the way some animals have features that an evolutionary budget "shouldn't" allow. How do antlers, for example, provide a fitness advantage? The question carries a mistaken assumption, though. The antlers may not be a fitness advantage in themselves, they may be evidence that a fitness advantage exists, the strength and antler carrying ability of the animal. The elk or moose is "saying": "See how big and strong I am with these huge antlers. Look upon them and despair! All you females out there, you should mate with me!"

The antlers are both advertisement for the animals health and a guarantee that the ad is not bogus. The strength to carry them must be real, just like paying dividends for decades is evidence of a long term competence in the marketplace, and the results of it realized for the investor.

Yes the strength is real if the company can afford to carry those big antlers, er make that dividends. That ability to support and perhaps even increase the size of those dividends is reliant on those earnings and revenue growth and a payout ratio that leaves lots of room to grow. The ability for dividend growth companies to outperform likely lies in the traditional domain of value. And a low payout ratio signals that those companies are confident that they can put the majority of their cash to work, to grow the business.

Now I certainly challenged dividend growth investors who are "Seeking Alpha" to find the investment strategy and companies that lead to that outperform. Dividend growth on Seeking Alpha is influenced greatly by a few writers who place the portfolio income growth as the main objective with value taking a back seat. I certainly could be wrong but I don't think that trying to grow the income stream as the main metric is the path to total return. In the end, I think it all comes back to the revenue and the earnings and having the room and ability to grow those dividends.

Of course I've recently analyzed the returns of two popular dividend growth investors who are kind enough to offer public portfolios and write on Seeking Alpha. So far, they are unable to beat the market with the strategy of growing the income. Some will say the 4-year or 5-year plus time horizons are too short to evaluate, and that it's tough to beat the market over the period, and that they expect to perhaps underpeform during raging bull markets for the S&P 500.

But the simple, passive, Dividend Aristocrats Index has beat the market over the last 5 years.

So certainly Dividend Growth can and perhaps should beat the market in a bull phase.

On the ETF front Vanguard Dividend Appreciation ETF (VIG) has beat the market from inception, May of 2006. VIG returned 77% outperforming the SPDR S&P 500 ETF's total return of 71.7%. The total return includes stock price appreciation and dividends.

Dividend Growth appears to be a very simple and concrete strategy that is easy to adopt and execute. The TD Dividend Growth Fund that I use for my kids' education investing plans has beat the market and that's with embarrassingly high fees (Canadians face the highest mutual fund fees in the developed world). The actual picks of the advisors beat the market by an even larger degree if we factor out those excessive fees.

The same story holds true for the managed Vanguard Dividend Growth Fund, it has a very decent beat of the market. Perhaps Dividend Growth is an area where some sensible patient active management can make some sense - if the fees are sensible.

Here's VDIGX vs. the market over the last ten years. That's a pretty decent outperform.

The current manager has been on duty from 2006, and he has some very decent (perhaps even better) market beating returns. Given that, why don't we fish where the fishin' is good, as they say? Let's look under the hood of two funds that have a defined formulae and method that has already shown to be able to deliver on dividend growth's promise. Let's see what kind of companies they are selecting.

I scanned through all of VDIGX and much of VIG and (manually) applied a simple screen of P/E ratio, 3-year revenue growth, 3-year earnings growth, 5-year dividend growth and that potentially all-important payout ratio. Here's the list of companies below the 50% payout ratio. A few others were removed as they looked a little 'sick'.

Company

P/E

Yield

Revenue Growth 3-yr

Earnings Growth

3-yr

Dividend Growth 5-yr

Payout Ratio

EOG Resources

23.1

.27

44.6%

98.2%

8.32%

9.09

CR Bard

17

.84

5.1%

225%

5.74%

9.53

Franklin Res*

14.5

.94

17.8%

22.5%

41%

11.8

Roper Ind

25

.60

15.7%

21.7%

15.8%

12.16

Ross Stores

18.5

1.10

45%

45%

29%

16.57

Ace Ltd+

9

2.58

14.4%

235%

54.3%

18.41

United Health

13.8

1.48

20%

16%

141%

18.77

Chubb Corp+*

9.4

2.3

2.6%

56.6%

6.24%

19.0

TJX Cos+

20.8

.95

19.8%

69%

19.97%

19.38

Murphy Oil

12.7

2.07

22%

20.6%

32.7%

20.02

Sigma-Aldrich*

23.4

.97

8%

7.6%

10.8%

20.85

Aflac*

9.5

2.31

7.9%

61%

18.3%

20.86

Oracle

16

1.28

2.3%

29%

20% (3-yr)

22.5

Walt Disney

22

1.07

12.3%

37.3%

18.4%

22.57

Dover Corp*

14.3

1.88

7.1%

21.7%

9.8%

25.66

PNC Financial

11.2

2.12

5.7%

31.1%

1.17%

23.12

CVS Caremark

19.4

1.5

17.9%

46%

28.8%

23.67

IBM+

12.1

3.8

Decline

10.7%

14.5%

24.62

Family Dollar Stores*

15.8

2.06

20%

17.4%

14.1%

25.73

Parker Hannifin

17.2

1.65

Flat

Decline

13.9%

25.98

Helmerich & Payne

14.5

2.55

27.9%

58.7%

33.45%

26.13

Nike+

26.7

1.23

16%

33.8%

13.7%

26.59

Sherwin-Willliams*

27.9

1.09

16.1%

75%

4.59%

27.0

Amgen

18.4

1.99

19.9%

66%

29% (3-yr)

27.86

Northrop Grumm

14.5

2.01

Decline

11.2%

8.55%

27.92

Ecolab Inc*

34.4

1.01

194%

65.6%

13.3%

28.51

Cintas Corp*

22.5

1.3

12%

32.1%

8.26%

28.7

Wells Fargo

12.2

2.53

Flat

38.5%

14.9%

29.07

Valspar

22.6

1.4%

3.7%

From Neg -

11.6%

30.0

Polaris Industries

25.6

1.39

42%

66%

18.7%

30.01

Medtronic+

16.7

1.9

1.9%

18.9%

8.2%

30.7

BlackRock Inc

17.5

2.61

15%

37%

30.4%

30.08

WW Grainger

21.9

1.51

16.8%

22%

18.7%

31.69

Lowe's+*

23.3

1.47

7.4%

51%

12%

32.5

Monsanto

24.5

1.52

21.1%

45.6%

10.4%

33.27

Exxon Mobil+

12.7

2.7

Decline

Decline

9.54%

33.12

VF Corp*

22.3

1.73

20.7%

35.7%

9.15%

33.16

PPG Industries*

27.3

1.25

1.5%

321%

3.05%

33.31

Norfolk Southern

15.7

2.28

Flat

10%

22.6%

33.36

Honeywell Int

18.8

1.96

6.4%

88.6%

8.7%

33.61

International Flavors & Fragrances

21.7

1.68

5.7%

31.3%

8.93%

33.9

Occidental Pet+

13.1

2.98

2%

Decline

16.92%

35.74

Brown-Forman

29.3

1.33

13.9%

6%

7.34%

35.78

Pentair Ltd*

29.4

1.29

216%

744%

8.02%

35.84

Tim Hortons

19.7

1.9

6.2%

11.7%

25.6%

36.0

Tiffany & Co

25.4

1.48

11.5%

4.8%

16.4%

36.03

Accenture PLC

16.2

2.29

1.9%

40%

26.9%

37.06

Harris Corp

17.3

2.32

Decline

Decline

15.75%

37.21

Microsoft

13.9

2.97

15%

None

14.98

37.2

Archer-Daniels*

21

2.26

Flat

Decline

7.89

37.29

McGraw Hill*

27.3

1.51

Decline

63%

16.5%

37.6

Walmart+

15.3

2.58

7.8%

10.6%

13.34%

38.59

Marsh & McLennan

20.3

2.04

6.3%

36.4%

3.86%

39.01

Church & Dwight

24.5

1.81

16%

31.9%

50.75%

39.34

Caterpillar

16.6

2.52

Decline

Decline

4.98%

39.4

Omnicom

19.5

2.21

5.1%

10%

22.8%

40

Praxair+

22.4

1.97

6%

7.4%

10.2%

40.3

JM Smucker

17.6

2.41

11.7%

30.6%

12.63%

40.47

Walgreen*

23.5

1.88

Flat

Decline

23%

40.9

Stryker

30.5

1.52

8.5%

Decline

29.6%

41.3

Becton Dickinson*

24.6

1.89

3.8%

Decline

10.86%

42.48

Illinois Tool*

22.1

2.09

Decline

Decline

6.66%

43.5

BG Group

27.5

1.63

44.59

National Fuel

23.24

2.0

9.6%

4.1%

2.9%

46.0

MDU Resources

23.2

2.1

10%

30%

13.6%

47.0

McCormick*

23.3

2.19

11.3%

Flat

9%

47.12

Genuine Parts*

19.4

2.69

13%

22.7%

7.15%

47.53

3 M Co*

19.3

2.63

4.2%

12.7%

4.91%

49.3

United Tech+

18.1

2.1

7.6%

13.4%

13%

49.9

Pepsico*

18.7

2.8

Flat

7%

6.3%

51.26

Fastenal

32.1

2.06

20%

24.7%

23%

52.92

Colgate Palmolive+*

26.8

2.13

4.1%

Decline

11.56%

56.0

Linear Tech

26.1

2.32

Flat

Decline

5.15%

57.14

Click to enlarge

For growth rates I used dailyfinance.com. When not available, I went to Google or Yahoo finance and then TD Waterhouse. Of course if you are seriously considering any company, double and triple check your figures. Data is not all that reliable "out there". Even the paid services you might use for value ratings are only as good as the initial inputs, and errors abound in the financial universe. Go to the audited source - the company and their reports.

Here are the tickers for those stocks: EOG Resources (NYSE:EOG), CR Bard (NYSE:BCR), Franklin Resources (NYSE:BEN), Roper Industries (NYSE:ROP), Ross Stores, (NASDAQ:ROST), Ace Limited (NYSE:ACE), United Health (NYSE:UNH), Chubb Corporation (NYSE:CB), TJX Companies (NYSE:TJX), Murphy Oil (NYSE:MUR), Sigma-Aldrich (NASDAQ:SIAL), Aflac (NYSE:AFL), Oracle (NASDAQ:ORCL), Walt Disney (NYSE:DIS), Dover Corporation (NYSE:DOV), PNC Financial (NYSE:PNC), CVS Caremark (NYSE:CVS), IBM (IMB), Family Dollar Stores (NYSE:FDO), Parker Hannifin (NYSE:PH), Helermerich & Payne (NYSE:HP), Nike (NYSE:NKE), Sherwin Williams (NYSE:SHW), Amgen (NASDAQ:AMGN), Northrop Grumman (NYSE:NOC), Ecolab Inc. (NYSE:ECL), Cintas Corp (NASDAQ:CTAS), Wells Fargo (NYSE:WFC), Valspar Corporation (NYSE:VAL), Polaris Industries (NYSE:PLL), Medtronic Inc. (NYSE:MDT), BlackRock Inc. (NYSE:BLK), W.W. Grainger (NYSE:GWW), Lowe's Companies (NYSE:LOW), Monsanto Company (NYSE:MON), Exxon Mobil (NYSE:XOM), VF Corporation (NYSE:VFC), PPG Industries (NYSE:PPG), Norfolk Southern (NYSE:NSC), Honeywell International (NYSE:HON)International Flavors & Fragrances (NYSE:IFF), Occidental Petroleum (NYSE:OXY), Brown-Forman (NYSE:BF.B), Pentair Limited (NYSE:PNR), Tim Hortons (THI), Tiffany & Co (NYSE:TIF), Accenture PLC (NYSE:ACN), Harris Corporation (NYSE:HRS), Microsoft (NASDAQ:MSFT), Archer Daniels Midland (NYSE:ADM), McGraw Hill (MHFI), Walmart (NYSE:WMT), Marsh & McLennan (NYSE:MMC), Church & Dwight (NYSE:CHD), Caterpillar (NYSE:CAT), Omnicom Group (NYSE:OMC), Praxair (NYSE:PX), JM Smucker (NYSE:SJM), Walgreen (WAG), Stryker (NYSE:SYK), Beckton Dickinson (NYSE:BDX), Illinois Tool Works (NYSE:ITW), National Fuel (NYSE:NFG), MDU Resources (NYSE:MDU), McCormick & Company (NYSE:MKC), Genuine Parts (NYSE:GPC), 3M Company (NYSE:MMM), United Technologies (NYSE:UTX), Pepsico (NYSE:PEP), Fastenal (NASDAQ:FAST), Colgate Palmolive (NYSE:CL), Linear Technology (NASDAQ:LLTC).

As you can see from the above table, those two funds are certainly acquiring many companies from the low payout ratio world. Any companies with a + symbol are in both VIG and VDIGX. Any company with the asterisk* is a member of the noble Dividend Aristocrats. Tim Hortons is my personal holding in that low yield low payout ratio world. I only hold three stocks. It's the only one I hold on purpose. It has a very tidy beat of the market, let's call that a double double.

To my eye there are many great companies on that list, with attractive recent growth histories and that low payout ratio that signals the ability to continue to raise those dividends. The key to total return is likely catching a few companies on the upswing, in their robust earnings and dividend growth phase. We can also see that there are many Dividend Aristocrats on that list, companies with that 25 year history of raising dividends and still with very low or reasonable payout ratios.

Have a look, let me know what you think. Would you consider lower yielding dividend payers if there is the potential of greater total return?

I'll be back next time with more from the high yield and low payout ratio world.

RISK!

Always remember to know your risk tolerance level, and create your portfolio accordingly. Many of the companies on that list will at times offer more volatility than the broader market.

Disclosure: I am long SPY. 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. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.