For my retirement, I am planning on relying exclusively on income from my dividend portfolio. In order to achieve the dividend crossover point, I would need to be prudent about saving and then investing the cash in quality income stocks at attractive valuations. The valuation part is generally easy to convey using simple numerical equations such as:
1) A 10-year record of annual dividend increases
2) Annual dividend growth exceeding 6%
3) A Price/Earnings ratio below 20
4) A dividend payout ratio below 60%
5) A minimum yield of 2.50%
I usually run this screen on the dividend champions list once a month and come up with ideas for further research or with alerts of stocks I like that are attractively priced. The more difficult task is evaluating quality when it comes to stocks. It is often said that beauty lies in the eyes of the beholder. When assessing quality in income stocks, I am often finding that what I identify as quality might be trashed by someone else.
In general, a quality company is the one that has strong brand name products and services that customers are willing to pay top dollar for. The products/services associated with this brand name represent quality and offer something of value to consumers that is only offered by this company. When a company is offering something that is uniquely distinguished, and is not a commodity, it can then charge a premium and can pass on cost increases to consumers if input costs increase.
For example, you can purchase cola products from many companies including PepsiCo (NYSE:PEP), RC Cola and Coca-Cola (NYSE:KO). However, for many consumers throughout the world, Coca-Cola offers a refreshing taste that is unique to the product they like. Even if someone was able to reverse engineer Coke, they would not be hugely successful because they would offer a largely untested product that the consumer is not familiar with. The company has managed to increase dividends for 52 years in a row, and pays an annual dividend of 3%.
The same is true for PepsiCo, which is a close rival of Coke in the Cola Wars. PepsiCo however is much more than a soft drink company. It also sells snacks to consumers such as Lays potato chips. The food business is incredibly stable as consumers are typically used to buying the brands they trust on their trips to the grocery store. In addition, it is much easier to charge higher prices for your product that the customer likes. The company has managed to increase dividends for 42 years in a row, and pays an annual dividend of 2.70%.
Another quality company is Wal-Mart Stores (NYSE:WMT), which is used by 100 million shoppers every week. The company is offering low prices for everyday items that shoppers ultimately purchase. Wal-Mart has been able to distinguish itself as the lowest price store as a result of its massive scale in the US. That has allowed it to dictate terms for its suppliers, many of which feel lucky to have their products on display at the largest retailer in the US. For a competitor to replicate this success, it would take an enormous amount of capital and years of experience. The company has managed to increase dividends for 41 years in a row, and pays an annual dividend of 2.50%.
International Business Machines (NYSE:IBM) is a quality technology company that I have always found to be slightly overvalued for my taste. I like the fact that the firm has been able to successfully transform itself into essentially what is now a global consulting company from the pure hardware behemoth it once was in the 1980s and early 1990s. The firm has achieved that by building relationships with clients, gaining their trust and offering services that provide great value. In business, relationships are very important. Technology is one aspect of the business where companies are less likely to venture with an unknown firm simply to save a few bucks. It would be much easier to justify selecting a company like IBM for an important technology implementation than a little known firm. Plus, if IBM consultants have a working knowledge of a company or industry, they would be much better at delivering value for their clients. The company has managed to increase dividends for 18 years in a row, and pays an annual dividend of 2%.
Philip Morris International (NYSE:PM) sells its Marlborough brand of cigarettes all over the world. Phillip Morris International has a high exposure to emerging markets where number of smokers is increasing along with their disposable incomes. Plus, it is not exposed to ruin if one country decides to ban tobacco outright. PMI has a wide moat because it would be extremely difficult for a new company to start and compete against the long established brands like Marlboro. Consumers generally stay with the brands they are used to buying. Cigarettes are an addictive product which offer very good pricing power. In addition, PMI has the economies of scale which ensure that its costs stay low relative to the competition. The company has managed to increase dividends for 6 years in a row, and pays an annual dividend of 4.50%.
Another firm I like is Kinder Morgan Energy Partners (NYSE:KMP). This master limited partnership has the longest network of oil and gas pipelines in the US. It also has pipelines transporting oil and gas in Canada as well. The beauty of the pipeline business is that it is federally regulated, and that companies that build pipelines seldom have competition. In essence, they are natural monopolies that connect the operators of oil and gas wells with refineries and other end users, while receiving a toll charge. The amount of oil and gas consumed in the US is remarkably stable, which is why a company with little competition that manages to charge toll type rates that are indexed with inflation seems like a good idea. The company has managed to increase dividends for 18 years in a row, and pays an annual dividend of 7%.
The last company on the list is McDonald's (NYSE:MCD). There are over 35,000 restaurants worldwide which bear the name McDonald's. Over 80% of those restaurants are franchised, which means that McDonald's is earning a boatload of royalties off those restaurants merely for their right of using the strong brand name, without taking the risk and significant capital expenditures associated with restaurants. These franchise agreements last several decades, which all but ensures a regular stream of cash being sent to headquarters. In many cases however the company also owns the real estate under the restaurants (both company and franchised), which is a hidden asset on the balance sheet, since many locations are on busy intersections and therefore extremely valuable. Plus, consumers like McDonald's, which is always quick to look for new opportunities for growth such as drive-through windows, new markets, change in menus, expanding store hours or drive-through lanes, etc. The company has managed to increase dividends for 38 years in a row, and pays an annual dividend of 3.20%.
What makes these investments sleep well at night ones is the fact that their income is produced by a diverse set of divisions, geographies and products. Plus, I find them to be fairly valued in today's market, and I believe they have bright futures that would bring in more earnings and dividend income for shareholders in the decades ahead.
Disclosure: I am long IBM, PEP, KO, MCD, KMR, KMI, WMT, PM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.