Dividend Growth Investors: Create Your Own Sense Of Value

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Includes: AAPL, ACN, BA, COST, CSCO, F, HON, IBM, JNJ, KMB, KO, O, PG, PSEC, TOL, XOM
by: Adam Aloisi

Summary

Value is an overused, sometimes ambiguous term in the investment field.

There are a variety of ways that a dividend growth investor can judge how a specific security can provide value in a portfolio.

Is higher-yield a value-add for the dividend growth investor?

Learn to connect your own personality dots, building a portfolio appropriate for your risk tolerance, goals, and general sense of value.

Of all the terminology used by equity investment analysts and strategists, the word "value" is probably one of the most overused and ambiguous descriptives. Value is often used to portray overarching investment strategies, individual security price relative to other deemed expensive options ("cheapness"), and as a standalone conclusion affiliated with a variety of other intrinsic and quantitative property calculations, like P/E, P/B/ or PEG for example.

Growth, seen in terms of strategy, is somewhat of a counterpart to value with expectations for quickly ramping earnings and price growth, but sans "cheapness" qualities inherent in a more value-focused strategy. Higher risk, more aggressive, even speculative stock selection methods would be viewed as more growth than value oriented.

The lines between the two can oftentimes be blurred, however. Certain stocks may end up in both value and growth designated-type portfolios. But while one can opine present, point-in-time value or growth attributes, only in hindsight can one conclude whether any specific thesis or characterization proves correct or not. A perceived value stock could prove to be a value trap, and a growth stock that doesn't pan out might turn out to be an "Enron."

Value Through The Dividend Growth Lens

In the dividend growth, and more generally, the income-investing realm, value can be judged in an even larger subjective light. Investors at different points in life or with varying risk tolerances can be seen as having vastly opposing senses of what defines equity- or fixed-income value.

Risk assessment by dividend growth investors tends to skew toward underlying sources of income. This is one of the reasons that consumer products companies selling non-durables tend to represent core positions in many DG portfolios. While quantitative value in terms of simple earnings and enterprise data may not appear great, there is qualitative significance involved in product line, predictability of the cash flow stream, and dividend growth preoccupation on the part of management.

It might be fairly simple to project the amount of soda, shampoo, and diapers consumers might be purchasing in future years, while it may be a bit more difficult to assume year-over-year gains in higher priced durables like car sales, enterprise Internet hardware, and new home purchases. It's certainly one of the reasons that the market puts a general premium on companies like Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), and Kimberly-Clark (NYSE:KMB), but tends to discount names like Ford (NYSE:F), Cisco (NASDAQ:CSCO), and Toll Brothers (NYSE:TOL).

While I'm somewhat critical of backward looking analysis, dividend streaks, academic studies and the like, the market does put a quantitative premium on perceptions related to historical durability, managerial stewardship, and economic "moat." However, one must keep in mind that streaks do often come to an end, and that failure to look forward could dramatically impact expected results. Further, strictly in terms of valuation multiple, the higher one sits, the further it may fall if a premium is taken away.

Some total return advocates criticize the dividend growth mentality, and usually harp that by focusing on factors unrelated to price, DGers are destined to underperform. The sound retort from the DG camp is usually twofold: one, not every investor seeks to maximize total return, and two, it's much easier to predict year-over-year growth of a dividend relative to year-over-year growth in price. I suppose a final retort could be that some DGers may see total outperformance even though don't explicitly seek it.

The argument relative to price is easily demonstrated with any number of stocks during the recent "lost decade." For instance, Johnson & Johnson (NYSE:JNJ), a dividend growth favorite, saw its stock price hover above and below the $60 mark for 11 straight years (2002-2013). Yet, the company's dividend almost tripled over the same time frame.

Though a growing dividend won't ramp your wealth anywhere near as quickly as a growing stock price, it certainly represents a value-add during periods of market stagnation.

Current Yield And Higher Yield

Those focused in on an income stream find current yield an important data point. In today's equity world, investors can find nominal sub-1% yields all the way up to 20%+ in some circumstances. For investors with a well-diversified portfolio, blended equity yield of X% tends to be an overriding goal.

As the yield point rises, however, dividend growth opaqueness and risk perception also rise. Although that may not prove to be the case in all scenarios, it is unlikely that a 10% yielding company is in a position to raise its dividend by 10% a year. If a company's yield is high, it is likely that its payout ratio is also high, resulting in very little free capital for expansion of per share operating output or dividends.

Some investors may feel they are in a position where they may have to up blended yield in order to get to portfolio goals. While there may be value in certain high-yield corners today, the stability of income source or how the yield is generated is typically not of an investment grade variety. If you are buying something substantially below net asset or book value, like an mREIT or BDC, you can certainly claim quantitative value, but you're probably not going to be able to claim qualitative value. You're probably also not going to see any dependable dividend growth.

Prospect Capital (NASDAQ:PSEC), for example, trades at a substantial discount to its portfolio's NAV and yields nearly 14%. Great, but consider the fact the company cut its payout 25% 15 months ago and now finds itself again barely covering the dividend with NII. Its underlying portfolio is full of loans to immature, not-so-credit-worthy clientele, and its external advisory situation has also been a hot button contention of management alignment. And for now, you might as well forget about dividend growth.

Still there will always be examples where a high-yield situation performs much better than a lower-yielding peer, so to summarily discount value in the high-yield space may be shortsighted. On the other hand, building a portfolio exclusively with high-yield positions with clear qualitative issues may not be so bright either.

All in, when adding high-yield to a lower-yielding dividend growth portfolio, you may be raising blended yield, but you are decreasing the dividend growth rate and probably the overall durability of your income stream. Whether or not that situation is seen as a value-add or not may vary from investor to investor.

Connect Your Own Value Dots

I can sit here and opine that you buy Honeywell (NYSE:HON), Apple (NASDAQ:AAPL), Costco (NASDAQ:COST), and Accenture (NYSE:ACN) - 4 of my larger dividend-paying holdings - because I think you will see tremendous long-term dividend growth from them. However, if you bought equal blocks of all 4, your blended yield would equal a whole buck seventy-five, 50 basis points lower than a large-cap index. I can easily sell you on their qualitative value aspects, but I can't necessarily sell you on their quantitative value aspects - with the possible exception of Apple.

If it makes more sense for you to buy Realty Income (NYSE:O), IBM (NYSE:IBM), Exxon Mobil (NYSE:XOM), and Boeing (NYSE:BA) at more than double the current yield, I would encourage you to possibly pursue that approach as well. Those 4 represent a mix of positive quantitative and qualitative attributes, but the longer-term dividend growth probably will be far less robust compared to the aforementioned names.

Portfolio building, management, or tear down is a highly personal concept. Varying yield points and asset types afford dividend investors flexibility to include security attributes that are important, while excluding those that may not hold as much personal weight.

Never assume that what others see value in represents value for yourself or vice versa.

Disclosure: I am/we are long AAPL,CSCO,JNJ,ACN,BA,HON,COST,XOM.

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.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.