The Next Generation Of Dividend Growth Stocks

Includes: ANTM, CSCO, MCD, MOS, SYY, T
by: The Financial Lexicon

If you are a dividend growth investor who has loaded up on all the well-known names, it may be time to look for the next generation of dividend growth stocks. In the vast universe of equities, there are likely to be many candidates. Although, finding the right mix of solid businesses, acceptable current equity valuations, adequate starting dividend yields, and the strong potential for dividend growth will weed out many candidates. I have identified two companies that I think are worth putting on your radar screen: WellPoint (WLP) and Cisco Systems (CSCO).

When investing for dividend growth, an investor will typically have a very long time horizon. That is, after all, how you eventually capture the dividend growth over time. Depending on how long your time horizon is and what your risk tolerance is, you may view today's prices for WellPoint and Cisco as attractive or not attractive. The purpose of this article is not to argue whether these stocks are currently worth buying from a valuation perspective. Instead, I want to share why WellPoint and Cisco are showing the early signs of becoming future dividend growth stocks.

In order to find dividend growth candidates, it's important to know some of the characteristics that are similar across dividend growth stocks. Solid earnings growth, free cash flow, and/or low dividend payout ratios are definitely important considerations. But another very important feature is the predictable pattern of dividend increases. The predictable pattern that is most common among dividend growth stocks is to pay a quarterly dividend and to raise the quarterly dividend after four consecutive identical payouts.

While a company like Mosaic (MOS) sports a low dividend payout ratio and has certainly increased its dividend by an incredible amount in 2012 (from $0.05 cents to $0.25), it doesn't yet exhibit the pattern of predictable increases to make me confident it will continue to increase its dividend on a regular basis going forward. Instead, over the past few years, Mosaic spent most of its time at $0.05, randomly threw a special dividend into the mix in 2009, and then increased its dividend by at least 100% during two consecutive quarters in 2012. Don't get me wrong, the special dividend and consecutive quarters of massive dividend increases are great. But for the dividend growth investor looking for reliable increases over time, a predictable pattern is more helpful for future income planning needs.

Often, the focus among dividend growth investors is to find companies that have shown the tendency to increase dividends on a regular basis over many years. However, it is also worthwhile to keep on your radar screen companies that only recently initiated dividends and after the first four consecutive identical payouts immediately raised the dividend. These are companies that have very quickly shown the willingness to raise their dividends and did so for the first time using the predictable pattern so common in dividend growth stocks. Two such companies are WellPoint and Cisco Systems.

WellPoint, one of the largest health benefits companies in the U.S., initiated a quarterly dividend in early 2011 at $0.25 per share. After four consecutive $0.25 payouts, the company raised the dividend 15% to $0.2875. In September, the company is expected to make its third consecutive $0.2875 payout. If the company raises its dividend again in the first quarter of 2013, that would be confirmation for me that we have a future dividend growth player on our hands.

Cisco Systems is in a similar boat as WellPoint. Cisco initiated a dividend in early 2011 at $0.06 per share, and after four consecutive $0.06 payouts, it raised the dividend by 33.33% to $0.08 per share. If Cisco raises its dividend again beginning with its expected April 2013 ex-dividend date, that would be confirmation that we have another dividend growth stock on our hands.

Of course, at their current 2.10% and 1.92% yields, WellPoint and Cisco's dividends aren't in the same ballpark as some of the better known dividend growth stocks. With that said, often two features of soon-to-be dividend growth stocks are that the dividends are initiated at low payout ratios and that the early dividend increases are quite substantial. As a result of this, it is not unusual to find the newer dividend growth companies increasing dividends at rates not only far in excess of inflation, but also far in excess of some of the more mature dividend growth stocks. This isn't true across the board. McDonald's (MCD) is an example of a long-standing dividend growth company hiking dividends at double-digit rates in recent years.

However, there are others, such as AT&T (T) that have slowed their dividend growth to a point that it may make sense to favor a much faster growing dividend from another company despite a currently lower yield. Naturally, valuations matter, and you shouldn't simply roll out of one stock into another simply because of the yield. But, if you believe the lower dividend yield of a WellPoint or a Cisco will eventually turn into a higher yield-on-cost than you will get from investing new money in AT&T, it makes sense to at least consider the alternative. If you believe AT&T is likely to continue its recent pattern of annual one-cent increases to its quarterly dividend and Cisco is likely to have several more years of roughly 20% dividend growth (most recent dividend growth of 33%), then it won't take that many years for Cisco's dividend to surpass that of AT&T's based on shares purchased at current levels.

If you believe Cisco can afford to make and has the willingness to make $0.2389 or greater quarterly dividend payments six years from now, then the yield on cost based the recent closing price would be 5.73%. This would compare to an AT&T yield on cost of 5.32% based on six more one-cent increases to the quarterly dividend. There are so many assumptions that must be made about the future when doing these sorts of comparisons, including whether Cisco would be able to maintain stronger dividend hikes than AT&T beyond year six in order to make up for the lower dividend yields prior to year six. However, if you believe brighter days lie ahead for lower paying potential dividend growth stocks than for more mature dividend growth players, it is worth making this type of comparison.

In addition to AT&T, another dividend growth company slowing the growth of its dividend to a trickle in recent years is Sysco (SYY). Its last three dividend hikes were 4.167%, 4%, and 3.85%. If Sysco follows its recent pattern of annual one-cent hikes to its quarterly dividend, the dividend growth would be 3.70%, 3.57%, 3.45%, 3.33% and 3.23% over the next five years. That would provide a 4.39% yield on cost five years from now based its recent close of $29.13. To match that yield on cost, WellPoint would need to grow its quarterly dividend to $0.60 per share five years from now. That would be a dividend payout ratio of just 32.88% based on the low end of the company's 2012 guidance for earnings per share. At the moment, the company is expected to grow its earnings over the next five years. This means the payout ratio would be even lower based on expected earnings five years from now. In other words, a $0.60 quarterly dividend for WellPoint five years from now is quite achievable.

For those investors tapped out regarding their allocation to the better known dividend growth stocks, searching for companies that have initiated dividends in recent years, have hiked according to the common predictable pattern mentioned above, and have the means to grow the dividend over time is worth considering. Furthermore, when searching for some of these potential dividend growth stocks, don’t be afraid to target current dividend yields around 2%. Although that may be a bit lower than where dividend growth investors typically like to start, if you find companies with the willingness and the capacity to raise the dividend at double-digit annual rates for some time to come, you can quickly realize a much higher yield on cost. WellPoint and Cisco Systems are two such candidates.

Disclosure: I am long CSCO, T, SYY.