One of the biggest myths about dividend investing is that companies which pay a dividend offer no growth, and thus they pay the distribution in order to keep their long term investors. Many naysayers believe that a company that does not reinvest all of its profits back into the business should be sold.
In my experience as a dividend investor, I have seen only one company which has successfully managed to reinvest all of its profits. The reason why this company was so successful in reinvesting those profits was because of the genius of its asset allocator – Warren Buffett. In retrospect, Warren Buffett is a closet dividend investor, who invests in companies generating sufficient extra cashflows that allows him to exercise his investing prowess and buy assets at a discount.
Even the Oracle of Omaha, however, is not immune to the laws of diminishing returns or investment mistakes that large capital bases and venturing in unfamiliar industries brings. There isn’t any other company like Berkshire Hathaway (BRK.B), which has managed to grow for four or five decades, while reinvesting all of its profits and delivering consistent returns on investment.
Buffett is not the only famous investor who spots attractive opportunities and holds on to them, while receiving dividends. Ben Graham, who was Buffett’s teacher and mentor in the field of value investing, said that the purpose of a company is to pay dividends to its owners. Without sharing any of the returns that the business supposedly generated, these returns are suspect to ordinary investors, who typically have no say in the way the company operates.
Most exceptional businesses have achieved an optimal balance between reinvesting profits back in the business and distributing them to shareholders. Coincidentally, some of the best dividend stocks, which boast long records of consistent dividend increases also happen to generate high returns on equity. These businesses have strong competitive advantages but at the same time they understand that re-investing all of their profits back in the business would not automatically generate the same returns on equity. As a result they are able to throw off plenty of free cash to their shareholders, which is probably one of the reasons why investors like Buffett look for opportunities that deliver high returns on equity.
I have outlined several dividend stocks with high returns on equity to illustrate my point:
- Medtronic, Inc. (MDT) develops, manufactures, and sells device-based medical therapies worldwide. This dividend champion has raised distributions for 33 years in a row. Returns on equity have remained above 19% for the majority of the past decade. Overall the ROE increased steadily over the past decade. ROE - 22.55% (analysis).
- Automatic Data Processing, Inc. (ADP) provides technology-based outsourcing solutions to employers, and vehicle retailers and manufacturers. This dividend aristocrat has raised dividends for 35 consecutive years. Over the past decade, the return on equity has remained in a tight range between 17% and 26%. ROE - 22.43% (analysis).
- Wal-Mart Stores, Inc. operates retail stores in various formats worldwide. This S&P Dividend Aristocrat has consistently increased dividends every year for 36 years. Over the past 20 years the return on equity has firmly remained above 20%. ROE - 21.08% (analysis).
- McDonald’s Corporation (MCD), together with its subsidiaries, franchises and operates McDonald’s restaurants in the food service industry worldwide. The company is also a dividend aristocrat, which has been consistently increasing its dividends for 33 consecutive years. The ROE has been increasing since it hit a low of 14 in 2002. Recently it hit 30%, and has stayed above that level for two consecutive years. ROE - 33.20% (analysis).
- Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. JNJ has been consistently increasing its dividend for 48 consecutive years. Over the past decade the ROE has remained largely between 25% and 30%, with the exception of 2006 and 2007. ROE - 26.35% (analysis).
- The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. Coca-Cola has paid uninterrupted dividends on its common stock since 1893 and increased payments to common shareholders every year for 48 years. The return on equity has been in a decline after hitting a high in 2001. It has stabilized since 2005 at a very impressive 30%. ROE - 30.15% (analysis).
- United Technologies Corporation (UTX) provides technology products and services to the building systems and aerospace industries worldwide. The company is also a dividend achiever, which has been consistently increasing its dividends for 16 consecutive years. Over the past decade the return on equity has remained largely between a low of 20% in 2005 and a high of 25% in 2008. ROE - 21.28% (analysis).
- Kimberly-Clark Corporation (KMB), together with its subsidiaries, engages in the manufacture and marketing of health and hygiene products worldwide. This dividend aristocrat has boosted distributions for 38 years in a row. The return on equity has fluctuated between a low of 25.70% in 2006 and a high of 39.4% in 2009. Over the past few years it has remained above 30%, which is impressive. ROE - 40.59%. (analysis).
- Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. The company is a component of the S&P 500 and the dividend aristocrat indexes. Over the past decade the ROE has largely remained between 12% and 28% after falling from its 2000 highs over 34%. ROE - 28.49% (analysis).
- Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. It operates in two segments, Oral, Personal, and Home Care; and Pet Nutrition. Over the past decade, the return on equity has been truly phenomenal, having never fallen below 80% since 2000. This dividend champion has increased dividends for 47 years in a row. ROE - 97.74% (analysis).
Disclosure: Author is long all stocks mentioned above.