Should Dividend Growth Investors Disregard Dividend Freezes From the 2008-09 Crisis?

 |  Includes: BLK, CATO
by: Low Sweat Investing

Like any strategy, investing for income via dividend growth requires discipline. Set up some guidelines that make sense for your goals, skills, risk tolerance and so forth. Then learn and improve, expanding what works and refining or rejecting what doesn't.

Sure, you might also invest in other assets, using other strategies and approaches. But if you're willing to invest in just about anything you don't have a strategy, you have a compulsion.

Following a strategy means you miss opportunities that fall outside your chosen approach, just like the flinty value investors who missed boatloads of bucks passing up Google (NASDAQ:GOOG). But they don't seem to mind off-strategy misses and neither should you. Strategy is as much a discipline of exclusion as a focus on inclusion. Ask Warren Buffett how he handles stocks outside his “circle of competence” when he invests for Berkshire Hathaway (NYSE:BRK.B). He ignores them.

One common guideline for dividend-growth strategies is to require some minimum number of annual dividend hikes. Raise your dividend 10 years, then call me in the morning. Cut your dividend and I won't speak to you for a decade. Or something like that.

Major Meltdown 2008 created the paradox of the dividend freeze. The worst period for dividends since the Great Depression saw good companies with good dividend-growth records and good management forego dividend increases -- arguably a good idea when an historic credit crunch induces a near-record economic crash. The paradox is that some hardcore dividend-growth investors, myself included, continued holding such dividend freezers, even though we would never buy them based on our strategy discipline.

But if you own a freezer, you own a freezer. When you bought it doesn’t change that. So I think this muddle is worth exploring. And for a worthwhile exploration, we'll need to get beyond Psych 101 sophomorics about denial, familiarity, affirmation and similar mumbo-jumbo that won’t mean squat the next time you're deciding whether to buy or sell a stock.

So let's just look at some stocks instead ... but not such a close look that we stray from income strategy into stock picking. Articles need a strategy too.

Take the stock of a company that hiked dividends for a decade, averaging double digit boosts. And let's say the company made it clear it will continue to raise dividends in line with long-run earnings growth, likely near double digits as well. Then we’ll say the stock yields 3.2% today. Sound good so far?

The company is Cato Corporation (NYSE:CATO) a discount retailer of middle-market women’s clothing since 1946, with roughly 1,300 stores in 31 states. Some quick CATO fundamentals: P/E below 14, P/CF about 9, ROE at 19 with no debt and gobs of free cash flow. Cyclical but growing revenues and earnings. Including the recent deep recession, 10-year EPS growth averages just under 7%. Current payout ratio: 34%. And with a market cap of about $800 million, there’s plenty of room to get bigger.

But now, sadly, let’s watch the dream come crashing down. CATO froze its dividend for 2008-09, probably a smart move for a well-managed small cyclical … but a freeze is a freeze, right? And even though the company rebounded with dividend boosts of 12% in 2010 then 24% this year, well … a freeze is a freeze.

Even with the resulting 12 quarters of flat dividends CATO shows trailing 10-year dividend growth averaging nearly 11%. And had the company held dividends steady “only” 11 quarters, then raised by a penny, it’d now be a 14-year dividend darling invited to every dinner party in town. That's a mighty big missing penny.

Or how about BlackRock (NYSE:BLK), the investment firm and ETF provider? The largest asset manager in the world, BLK also enjoys “the widest moat in the asset-management industry,” according to Morningstar.

Does anyone doubt the competitive advantage BLK’s massive ETF business brings vs. traditional mutual fund providers like T. Rowe Price (NASDAQ:TROW), Eaton Vance (NYSE:EV), and Franklin Resources (NYSE:BEN), all with 20+ years of dividend growth behind them? But BLK hunkered down with a dividend freeze in 2009, after five straight years of hikes. Then the company boosted by 28% in 2010 and 37% this year.

BLK’s nearly 3% yield and 29% average five-year dividend growth, including the 2009 freeze, clobber those three old-time mutual fund companies. And BLK’s consensus double-digit earnings growth, forecasted over the next one, two and five years, will cost you a P/E just over 16.

So how might an action-oriented investor translate all this? First, neither CATO nor BLK is for the faint-hearted. Retailer profits depend on consumer spending and gross margins, and CATO recently said the second half of 2011 could be tough. Meanwhile, asset managers perform best when asset prices go up. So if you don’t like the market or the economy, you can’t like these stocks near-term. Not to mention those pesky dividend freezes, well past though still on record.

But bigger picture, if part of strategy discipline is learning and refining, what can we learn about companies that fell from our favored dividend-growth lists because they merely maintained their dividends during the most extraordinary financial and economic upheaval in nearly a century? In some cases, we might learn these are superb companies, with strong dividend policies and stellar long-run prospects.

So for my current and future portfolio choices, I’m issuing a get-out-of-jail-free card if a company’s sole blemish is maintaining its dividend during the Major Meltdown. If it’s a buy except for that freeze, then it’s a buy so long as subsequent dividend boosts are big enough to get dividend growth on trend again. That seems right to me. And that’s why I’m holding CATO, which I’ve owned several years, and why I recently bought BLK.

Finally, for some research and discussion on why dividend-growth is such a cool strategy, click here.

Disclosure: I am long BLK, CATO.