My Model Dividend Growth Portfolio (Part 2): The Investments

Includes: ABM, AFL, BDX, TMP, WFC
by: Convex Strategies

This is the second article in a three-part series discussing my model DGI portfolio: Part 1.

Seeking Alpha has quite the collection of dividend growth investors. Though I don't currently maintain a dividend growth portfolio of my own, I am in the process of modeling one and should begin the building stage by mid-2013.

As a result, though I admittedly lack the field experience of most contributors in this investment arena, this series will hopefully generate some quality discussion about the strategy as a whole, in addition to the individual investment ideas.

In part 1, I discussed my specific long-term investment strategy. Essentially, what I'm aiming to accomplish is the construction of a portfolio that consists of dividend growth stocks that will produce gigantic yields on costs by the time I'm retired, which I figure is at least 50-60 years away. For now, given my age and resources, I also manage a trading account in which I employ futures, options, and short-selling strategies. I plan to continue utilizing this account alongside my dividend growth portfolio to hedge out incurred macro risks.

Given my exceptionally long investment horizon, I'm able to consider stocks with far lower current yields than most who use this strategy. However, I do prefer equities with yields of at least 3%.

Aside from the dividend component, I'm looking for the following characteristics:

  • Unique, non-commoditized products sold by firms that earn sustainable profits above the normal rate of return
  • Strong brand names in its market
  • Good management (this is a major intangible)
  • Strong returns on equity
  • Growth catalysts
  • Minimal "blowout" risk -- Lehman's highly levered exposure to real estate and CDOs comes to mind
  • Predictable cash flows (definitely easier said than done, but is far more realistic in something like consumer staples vs. semiconductors or autos)
  • Economies of scale

And that's about it. I have a decent amount of confidence that I know a good business when I see one, and I'll constantly reevaluate and question my holdings.

For now, here are the first five (out of 10) holdings for my model portfolio:

Tompkins Financial (NYSEMKT:TMP)

I've written entire articles on TMP; feel free to click the link for more in-depth info.

I find Tompkins to be a particularly attractive dividend growth stock. The company is regional bank located in upstate New York, and is a perfect example of low-risk, profitable commercial banking. The company has been a regional name for 175 years, has strong retention rates, and is very good at cross-selling.

The company recently closed its acquisition of VIST financial, which adds $1.4 billion in assets and will be accretive to both free cash flow and EPS by 2013. VIST was acquired at 70% of book value, and gives TMP more low-risk assets from which to generate additional profits. Annual EPS growth has been about 5% for the last five years.

The company trades at 7 times trailing FCF; given its durable and consistent performance, this is far too cheap. It currently yields 3.8%, and this has grown at a rate of 6% annually for the last five years. The payout ratio based on FCF is a mere 29%, and the shareholder friendly management expects to increase the dividend substantially over the next several years.

Becton, Dickinson and Company (NYSE:BDX)

BDX is another one of those consistent performers that doesn't get a lot of coverage.

The company sells syringes, diagnostic systems, IVs, insulin-injection systems (there's your growth catalyst), drug delivery systems, and a variety of similar medical-related products.

The economics of this business aren't absolutely ideal; supplies like syringes are largely commoditized, and U.S. medical supplies companies like BDX have incurred plenty of competition overseas where low-cost producers have flooded the market. That being said, BDX has about 70% of the market share for syringes and strong sales relationships thanks to its highly recognized and trusted brand name. While the products that BDX sells may not be terribly unique, its brand name generates a huge competitive advantage. This is similar to the dynamics in the soft-drink industry; Pepsi often wins in blind taste contests, but consumers drink more Coca-Cola because of the brand name.

The insulin-injection market has been a gigantic sales catalyst for BDX, with its overall diabetes segment growing at about 11% for the last few years. Total sales have grown every year since 2007, resulting in growth of 5.6% annually since that time. Due to a large ongoing share buyback program that has bought 8% of the company's outstanding stock since 2008, annualized EPS growth of 14.6% over the past five years, and a low payout ratio (30% based on FCF) dividend growth has been 13% annually since 2007.

Trading at only 12.8 trailing free cash flows, the company is attractively valued.

ABM Industries (NYSE:ABM)

You've probably never heard of ABM, and that's a good thing for prospective shareholders. The company's services are even more boring than the name. ABM operates the following segments: janitorial, facility solutions, parking, and security.

The janitorial business includes carpet cleaning, window washing, floor and furniture polishing, snow cleanup, and extermination. These services are mostly under 1-3 year contracts with automatic renewals.

ABM's engineering services (a portion of facility solutions) aim to reduce fixed costs and improve the operating lives of assets. Specifically, reduction of energy consumption, performance testing, and energy audits.

ABM operates parking lots and garages at a variety of different facilities; the segment generated over $600 million in 2011 revenues, a 31% annual increase.

The company's security operations include undercover work, white collar crime investigation, and fire monitoring. This is ABM's smallest segment by sales.

While the barriers to entry aren't particularly high in this business, the nature of the business is unexciting, largely recession-proof, and the revenues are recurring. This is a classic, steady growing, "old-economy" business.

Revenue is growing at an annual rate above 10%, while EPS has been growing at about 6% per year. The EPS growth rate has picked up significantly in the past three years, and analysts estimate $1.39 in fiscal 2012, and $1.55 in fiscal 2013. The company trades at an exceptionally low price to FCF multiple of about 7.5.

ABM's strong cash flow generation has enabled it to increase its dividend for 45 straight years. Currently yielding 3.10%, its FCF payout ratio is under 25%, and the DGR has averaged about 4% for the last five years. I expect the dividend growth rate to pick up over the next few years.

Aflac (NYSE:AFL)

For those not familiar with Aflac's business, here is a brief breakdown taken from an article I wrote a short while ago:

"Aflac's niche is supplemental insurance, which is typically used in conjunction with primary insurance. Some specific offerings include Lump-sum cancer, dental, and accident coverage.

The business model is low-cost in nature, is unique, and generates excellent returns on equity; over the past five years, ROE has averaged 18%."

Aflac does most of its business in Japan, so 90% of its overall investments are allocated within the Japanese investment portfolio. The company has retention rates of 95% in Japan.

The absolute, total exposure to risky European sovereigns is $17 billion, which amounts to almost 20% of the overall portfolio. While major write-downs would obviously put pressure on AFL (and possibly result in an equity raise), the company has already been impairing hundreds of millions in assets, and offloading undesirable holdings at higher values than it initially expected.

While its massive investment exposure to Japan's low rate environment and sovereign JGBs are obviously resulting in some investor concern, AFL has been investing more heavily in dollar denominated, domestic assets. Furthermore, those calling for a Japanese collapse have been consistently wrong, and may be misunderstanding the dynamics over there. While the combination of poor demographics, huge government deficits, and perpetual deflation is clearly worrisome, the central bank has been able to monetize much of the debt without spurring any sort of inflation. There's no end in sight to this for the next several years at least, since deflationary pressures are still strong.

Aflac's cash flow generation is astounding, and the company trades at less than two times FCF. Cash flow generation has been growing rapidly thanks to improvements in the investment portfolio and new insurance products that are driving double digit sales growth. The payout ratio is a low 24%, the current yield is 3%, and the 3-year dividend growth rate is 8.6%.

Wells Fargo (NYSE:WFC)

I can't stand most of the big banks, as the blow-up risk is very real, and banking is simply not going to be as profitable as it used to be. That being said, Wells Fargo is significantly different.

Known as the "king of cross-sell," WFC averages nearly 6 products per banking household in the U.S. This is a gigantic competitive advantage since most banks don't succeed in this endeavor, and the recurring revenue generation is a huge bonus.

With minimal exposure to investment banking, derivative and trading blow-up risk is vastly lower relative to its peers. While its massive exposure to the mortgage market has been difficult to manage during the last few years, it is going to be a boon as housing slowly recovers. WFC originated 34% of all residential mortgages in the 1st quarter, a testament to its massive presence in the housing market.

The performance speaks for itself, EPS has risen 95% since 2009, and analysts expect 2013 EPS of $3.67, up from FY 2012 EPS of $3.32. On this basis, the company is trading at 10.3 times earnings.

Considering the bank's excellent capital levels, its dividend is far higher than those of its competitors. Currently yielding 2.56% ($0.88 per share), the dividend has not yet returned to the pre-crisis $1.36 (4% at today's levels). While that sort of a distribution may be another couple of years away, it's definitely coming.

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