The 5-Year Rule in Dividend Growth Investing

by: David Van Knapp
This is the fourth in an occasional series about my public Dividend Growth Portfolio. The portfolio is designed to demonstrate how dividend-growth investing works. The first three articles were:
In this article, I want to expand on a particular element of my strategy for picking dividend-growth stocks: The 5-year rule. The rule simply says that a company must have raised its dividend for at least 5 consecutive years before it is eligible to be purchased for the Dividend Growth Portfolio.
The thinking is straightforward. Since the goal is reliable dividend growth, I want to select companies that grow their dividends reliably. Of course, no one can predict the future. Any company can cut, freeze, or eliminate its dividend at any time. But the past holds clues to the future. Clearly, a company that has already compiled a streak of consecutive annual dividend increases is displaying evidence that it might continue to do so. The 5-year rule is certainly not the only evidence one might seek, but it is an important part.
I use the 5-year rule as a hurdle requirement: If a company does not have at least a 5-year streak of raising its dividends, it is ineligible for consideration as a true dividend-growth stock.

At the moment, there are some really interesting examples of how this rule can steer investment money toward or away from certain stocks.

Big Banks

Recently, several “too big to fail” banks were given permission by the Fed to re-establish or raise dividends after the financial fiascoes and bailouts of recent years. Among those receiving permission:

  • Bank of NY Mellon (NYSE:BK) increased its dividend 44% to $0.13/share/quarter, resulting in a new yield of 1.8%.
  • BB&T Corporation (NYSE:BBT) increased its dividend 6.7% to $0.16/share/quarter and tacked on a special dividend of $0.01/share. The new yield is 2.4%.
  • Citigroup (NYSE:C) was given permission to pay a $0.01 dividend after they complete a 1-for-10 reverse stock split. This is an increase of infinity, since they’ve had no dividend since 2009.
  • JPMorgan Chase & Co. (NYSE:JPM) raised its dividend 400% to $0.25/share/quarter, climbing back within 35% of their pre-fiasco payout of $0.38. The new yield is 2.2%.
  • KeyCorp (NYSE:KEY) will increase its quarterly dividend 200% to $0.03 from $0.01, giving it a yield of 0.5%.
  • Fifth Third Bancorp (NASDAQ:FITB) increased its dividend 500% to $0.06/share/quarter, resulting in a yield of 1.7%.
  • PNC Financial Services (NYSE:PNC) will raise its quarterly dividend payout from $0.10 to $0.35 per share, giving it a yield of 2.2%.
  • State Street Corporation (NYSE:STT) jacked up its dividend 1700% to $0.18/share/quarter. The new yield is 1.7%.
  • U.S. Bancorp (NYSE:USB) increased its quarterly dividend 150% to $0.125/share, resulting in a 1.9% yield.
  • Wells Fargo (NYSE:WFC) issued a second dividend of $0.07 to go along with its regular dividend of $0.05. If the total of $0.12 can be considered its new quarterly payout, its new yield is 1.6%.
Many of these increases were accompanied by announcements of share buyback plans, and in addition, most of the new payout ratios are small enough (single digits to low-double-digits) that some would say that there is plenty of room for substantial future increases. Some writers have been very enthusiastic about the future dividends certain to flow from these banks which had been dividend-growth stalwarts until they weren’t. Phrases like “the banks are sound again” have been used. It is said that the Fed’s permissions indicate that the banks have recovered fully from the financial crisis, and that the decisions to repurchase shares send a clear signal that management views the stocks as undervalued.
Well, maybe. I think broad conclusions like that are premature. It takes more than an upgrade from critical condition, repayment of TARP funds, and decisions to ramp up dividends to give me any comfort level in these stocks as worthy of dividend-growth portfolios. The Citigroup permission (reverse stock split, $0.01 dividend thereafter) sounds more like a joke than an all-clear signal.
One bank not approved by the Fed was hapless Bank of America (NYSE:BAC), which asked to be allowed to raise its dividend "modestly" in the second half of the year, since it now has excess capital sloshing around. Before the Fed rejected its plan, BAC had already announced its intent to raise its dividend, which has been frozen at $0.01/share/quarter since 2008. Oops. Just yesterday, BAC reported that its first-quarter income fell 39% on higher costs related to its mortgage business and higher litigation expenses, and its stock price tanked on the news. According to AP, the bank is fighting lawsuits from investors and insurers who say they were duped into buying mortgage loans that were based on fraudulent documents. BAC has set aside over $5 billion to repurchase those mortgages. This is probably mostly a story on BAC individually, but the rejection of BAC’s dividend plan, followed by its dismal Q1 report, stands as a stark reminder that in banking these days, perhaps not everybody yet knows what they are doing. BAC’s blindness to its own shaky position strengthens my resolve to wait on all of them.

The clock has restarted on the banks that have raised their dividends. I’ll ask them to raise their dividends for the next four years to show whether they are really dividend stalwarts again. I hope they all make it. Maybe I’m missing the boat on some great increases here, but I’d rather be safe than sorry when it comes to dividend-growth investing.
General Electric
I used to smile when GE was categorized as an industrial company. Anyone who understood the company realized it was an old-fashioned conglomerate with stakes in many industries. Unfortunately, one of its divisions was a pure financial operation that, in fact, accounted for a high percentage of GE’s profits every year.
That operation failed along with the banks in 2008, pulling the entire company down with it. GE, after first announcing that its dividend was safe, then reversed itself and announced a cut a few weeks later in early 2009.
Since last July, GE has raised its dividend twice, from $0.10 to $0.12 to $0.14/share/quarter, giving it a projected yield of 2.8% (assuming no other increases for a year). That’s a good start, but GE won’t have a spot in my Dividend Growth Portfolio until 2015 at the earliest.
Technology Companies
When you think about technology companies, what images come to mind? Do you believe that tech companies are not supposed to be mature or to pay dividends? That they are supposed to recycle all their profits into R&D and acquisitions and grow, grow, grow? While it is often reflexively thought that tech companies don’t pay dividends, that is not the case. Tech no longer automatically means massive growth coupled with high valuations and no dividends. The fact is, several tech companies have been paying and raising dividends for years.
When you think about it, the technology sector has been around for a long time. I was unable to find when S&P/McGraw-Hill first introduced what is now called the Info Technology sector, but computers were commercialized in the 1940s; the transistor, integrated circuits, and the first networked computers in the 1950s; personal computers and cell phones in the 1970s; and the Internet in the 1990s.
Here is a sampling of tech companies that already have established dividend streaks:
  • Automatic Data Processing (NASDAQ:ADP), a business services provider, has one of the longest dividend-increase streaks you will find (36 years), meaning it already is a Dividend Champion. It is a stalwart in many dividend-growth portfolios. Its yield is just under 3%.
  • Computer Services (OTCQX:CSVI), a provider of technology services, is on a 22-year increase streak, with a yield of 1.6%.
  • IBM (NYSE:IBM), formally International Business Machines, has passed through several life-stages and managed to keep at the forefront of computer-based technology and related services. It has raised its dividend for 15 years and yields about 1.6%.
  • Linear Technology (NASDAQ:LLTC) has raised dividends for 19 years and yields about 2.8%.
What about other technology companies? Might there be future Dividend Champions somewhere? I have two nominees. But first…
Microsoft (NASDAQ:MSFT) strikes me as a cautionary tale about prematurely declaring a company to be a good dividend-growth stock when in fact it has not established a reliable dividend practice at all. After going many years with no dividend and building up a huge (and widely criticized) cash hoard, Microsoft has lurched through the following sequence (all payouts are per share):
  • Paid its first-ever dividend of $0.08 in early 2003, followed by a dividend of $0.16 in November. Total for 2003 = $0.24.
  • Declared in July, 2004 a dividend of 0.08 payable in September. At the same time, declared a massive “special” dividend of $3.00 payable in December. In September, declared a dividend of $0.08 payable on the same date in December as the special dividend. Total for 2004 = $3.16.
  • In 2005, began what may stand as a regular pattern of payouts in March, June, September, and December. The quarterly dividend was kept at $0.08 throughout 2005. Total for 2005 = $0.32.
  • In 2006, increased its dividend $0.01 twice. Total payout in 2006 = $0.37.
  • In 2007, raised its December dividend. Total for 2007 = $0.41.
  • In 2008, total payout = $0.46.
  • In 2009, made no increase. It paid the same $0.13/share each quarter, but its total payout went up, because the $0.13 was paid out in all four quarters. Total payout = $0.52.
  • In 2010, increased the last quarter’s payout. Total payout = $0.55.
What we have here is a company that, 8 years after declaring its first dividend, has not established any sort of reliable dividend practice or culture, although the pattern of paying 4 times/year has held since 2005. Its dividend has now gone up 8 years in a row (ignoring the special dividend), but the increases have been unpredictable. It would be hard to paint MSFT as a reliable dividend-raising company. It certainly has the cash and cash flow to be one, but I cannot see that it has made the necessary internal decisions or cultural shifts required to actually be one that dividend investors can rely upon. I am sure some critics would liken their stumbling around on the dividend front to their general operating mode for the last 10 years or so.
Here are my two nominees for future Dividend Champion status:
Microchip Technology Inc. (NASDAQ:MCHP), a developer of semiconductor products for various control applications, has increased its dividend for 9 years and yields 3.8%. From a standing start in 2002, it has gone from an initial annual dividend of $0.02 per share to $1.37 per share in 2010. (I am ignoring an extra dividend paid in December, 2010, an apparent acceleration of their first dividend of 2011 into 2010). That’s a 68x increase in 9 years. Unfortunately, its DGR slowed to 2% in 2010 (ignoring that extra dividend). I like MCHP because it does not try to be on the cutting edge in technological development. Instead, MCHP has focused in recent years on lower-end 8-bit microcontrollers that are suitable for a wide range of less technologically advanced devices. Its chips are used by tens of thousands of customers in automotive, computing, consumer, industrial, medical, and networking markets. In my opinion, MCHP is already a reliable dividend-growth company. I can see it becoming a Champion 16 years from now. MCHP is one of my Top 40 Dividend-Growth Stocks for 2011.
Intel (NASDAQ:INTC) seems to have become a reliable dividend-growth company. Founded in 1968, INTC is one of the oldest global technology titans. Its chips are ubiquitous. (Cue 4-note jingle and “Intel Inside” logo.) INTC got off to an inconsistent dividend start. It paid its first dividend in 1992; established a 4-times-per-year schedule and began raising its dividend in 1994; made only 3 payments in 1998 and cut the dividend too; resumed 4 payments in 1999; raised the dividend annually through 2001; and froze it in 2002-2003. But since then, it has been on a steady glide upwards, from $0.08/share in 2003 to $0.63 in 2010. That’s an 8x increase in 7 years. Notably, they maintained this pattern through the Great Recession. Its 5-year DGR is 15%, its increase in 2010 was 14%, and in 2011 is 15%. Its current yield is 3.6%, and it sports a low P/E ratio of just 10 (forward P/E = 9). I expect INTC may show up in a future Top 40 list.
There are a couple of notable newbie tech dividend payers.
  • Oracle (NASDAQ:ORCL), the dominant name in database software, initiated its first dividend in 2009 with 3 payments of a nickel for a total of $0.15/share, followed by 4 payments (with no increase) for a total of $0.20 last year. They have announced an increase to $0.06/share for 2011, which would imply a yield of 0.7%. Off to a slow but perhaps promising start. The company is still in an active acquisition and growth phase as well.
  • Cisco (NASDAQ:CSCO) is the worldwide leader in networking. On March 18th the company announced it first cash dividend of $0.06/share, implying a yield of 1.7%. The move was a little puzzling, as the company has had 4 consecutive quarters of disappointing earnings, and CEO John Chambers plans to take “bold steps and tough decisions” aimed at improving the company's performance. "Bottom line, we have lost some of the credibility that is foundational to Cisco's success - and we must earn it back," said Chambers. It seems strange to initiate a dividend in that kind of environment.

Please note that all references to Dividend Champions mean David Fish’s superb monthly document (pdf) of the same name. Also note that many of the stocks named in this article have sub-3% yields, which would exclude them from consideration as dividend-growth stocks under the 3% rule, another hurdle that I use. Finally, as always, perform your own due diligence before investing in anything.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.