Four Important Rules Of Blue-Chip Dividend Investing

Includes: BRK.B, BUD, CVX, HSY
by: Tim McAleenan Jr.

When I consider making an investment in the common stock of a company that pays a dividend, there are four thinks that are often at the top of my mind. I've shared them with you below:

1. Earnings per share growth, earnings per share growth, earnings per share growth. You know how when it comes valuing real estate, people repeat the word "location" three times in a row to drive home its importance? Well, with common stock investing, that's how I feel about earnings growth per share. It's the salve that cures all. If you own a company that grows earnings by 8-12% each year over the course of the business cycle, you can overcome self-inflicted obstacles such as modestly overpaying for a stock. It is the greatest predictor of dividend growth because it is the source of the dividend growth.

There is a reason why Coca-Cola (NYSE:KO) is the cornerstone stock of almost every portfolio. The volume goes up every year, the return on equity remains in that 25-30% sweet spot, and the earnings per share go up by 7-11% every year. Nothing is perfectly clockwork, but Coca-Cola is on the short list of companies that come close.

My favorite company is something like Chevron (NYSE:CVX) that understands how to calibrate the relationship between earnings per share growth and dividend growth perfectly: the company makes heavy capital expenditures to fuel top-line growth, it buys back a steady amount of stock (and actually retires it!) to enhance earnings per share growth, and these maneuvers allow Chevron to deliver 8-12% dividend growth to investors every year except when we are hovering around the bottom of the commodities business cycle when oil prices are low (as a reference point, the dividend "only" went up from $0.65 to $0.68 quarterly during the last oil price bust during the financial crisis).

The key is finding the blue-chip stocks that give you that 8-12% earnings per share growth. I like high single digit dividend growth, and the only way to find it on a sustainable basis is to deal with the companies that are able to grow their earnings by at least that amount over the long-term.

2. Fair or Cheap Valuation. I have a special fondness for Benjamin Graham's margin of safety principle because it makes so much common sense. If you pay less than what the stock is worth, you will earn returns that will be the product of the company's growth plus its P/E expansion towards fair valuation. If you pay fair value for a stock, your total returns will mirror the growth of the firm. And if you overpay for the stock, then you will earn total returns that are less than the growth of the firm because you have to deal with the P/E compression back to fair value.

It's a scene that plays out over and over again. Going back eleven years, Coca-Cola has grown its earnings by a little over 9% annually. Yet the total returns experienced by investors that bought at the worst time eleven years ago are just shy of 7%, including reinvested dividends. What explains this 2% spread? Overpaying. The way I see it is this: it is the job of the company's management to grow the business, but it is my responsibility to determine a reasonable price to pay for that ownership stake.

That's why I cannot buy a lot of my favorite blue-chip companies today. Personally, I can't wait to own Realty Income (NYSE:O). I can't wait to own Hershey (NYSE:HSY). I can't wait to own Brown Forman (NYSE:BF.A). They all provide great and reliable income. But oftentimes, sound dividend investing and total return investing walk hand in hand. If you insist on fair valuation or undervaluation to ensure satisfactory total return potential, you are also doing yourself a service as a dividend investor by getting a higher starting dividend yield. The actions that lead you to higher future income with a particular stock also lead you to higher total returns with the stock.

3. High Likelihood Of Future Dividend Growth. One thing I do not like is a company that has a lot of debt or other pre-existing commitments. Anheuser-Busch (NYSE:BUD) has over $44 billion in debt. How can that not put a drag on future growth? Money that could be spent growing the company or conducting share buybacks will be spent servicing debt. A large company like Anheuser Busch is already a lumbering giant as it is, and when you mix in the high debt, the likelihood of high future dividend growth greatly diminishes (incidentally, shareholders of the company may experience high dividend growth over the next five years because the company has indicated a desire to accelerate the payout ratio that has been artificially low since the 2008 merger, but once the target payout ratio is reached, any dividend growth thereafter is likely to be modest at best).

Companies with little capital requirements are a good starting place if you want to look for high dividend growth. Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B), once said that steel companies are the place where intelligent value investors lose their money. This is because they see low P/E ratios and the promise of higher dividends that are lurking "just around the corner", but those higher dividends rarely materialize because the nature of steel businesses is that they are so capital intensive that you cannot take a lot of money out of the company.

That's why I like companies like Visa (NYSE:V) and Disney (NYSE:DIS). Once Visa puts its infrastructure in place, there is not a whole lot of difference between having 1,000,000 users and 10,000,000 users. Sure, the latter is more expensive, but not proportionately so. As Visa continues to mature, investors will likely receive meaningful dividend growth when the Board of Directors decides to accelerate the payout ratio (the caveat would be if the company goes in the direction of stock buybacks instead).

Disney is a company that I do not write about from a dividend perspective all that much because it only makes its payouts annually and the company spends over four times as much money on stock buybacks as it does on dividends. Also, the current dividend yield is only a little above 1%. And it's not exactly priced at a discount right now. But the company generates obscene profits on its intellectual property, so much so that Charlie Munger once referred to Disney's vault of classic movies as an "oil well where you can put the oil back in the ground when you're done extracting it." For most of Disney's intellectual property, the capital needs are very low (it does not exactly cost a fortune to transition 'The Lion King' from VHS to DVD to get a new generation of kids hooked), and this provides a source of profits that could be readily deployed to shareholders (although the Disney Board has been on a buyback kick the last few years). Nevertheless, it has the kind of business model that has allowed shareholders to receive 10% annual dividend increases over the past five years, and Value Line predicts that Disney will grant investors 15% increases over the medium term.

3. Hedge Against Inflation. Everyone has their own approach to hedging against inflation, and I do not pretend to think that there is universal agreement on this topic. Some people like hard metals such as gold, silver, palladium, or whatever it may be. Personally, my temperament is such that I cannot bring myself to own a non-productive asset. I only limit what I consider "investments" to things that generate dividends, rent, or interest, although I'd be willing to own a few select non-dividend paying companies if certain scenarios were to rise.

Well-branded consumer staples are better inflation hedges than most people think. Companies like Coca-Cola and PepsiCo (NYSE:PEP) would be good candidates of companies to own during inflationary times. A lot of times, people think consumer staples are bad inflation hedges because the nature of consumer staple price increases can be lagging in certain circumstances.

For example, sometimes you'll hear someone say, "Inflation was measured at over 10% for most of 1979. Did your Coca-Cola stock raise prices by 17% and raise dividends by 17% to maintain the status quo ante of purchasing power increases that existed before the high inflation?" Some people will merely look at the fact that there was no direct linear correlation between high inflation and Coca-Cola price increases and then conclude that a company like Coca-Cola is not a good inflation hedge. That kind of analysis discounts the fact that Coca-Cola raised its prices far in excess of the 3-4% inflation rates in the early and mid 1980s, therefore providing a hedge against inflation in a delayed manner.

My main style of hedging against inflation involves owning the big energy companies like Exxon (NYSE:XOM), ConocoPhillips (NYSE:COP), BP (NYSE:BP), and Royal Dutch Shell (NYSE:RDS.B). If we have inflation of 10% in this country, what do you think the price of oil is going to be doing? It probably won't be cratering. I can't envision many scenarios in which the United States would experience something like 8-10% annual inflation while the price of oil fell to $60. As long as there is no commodities bust accompanying the period of inflation, I would think that Exxon and Conoco dividends would provide a nice hideout while the dollar is being trashed.

Of course, the most straightforward way to hedge against inflation with a dividend stock would be to own a company like Visa or Mastercard (NYSE:MA). Both of those companies operate on the gross dollar volume model, meaning that the companies automatically make more as customers spend more during inflationary times. The big caveats are that both companies offer very low starter yields of less than 1%, and Mastercard does not hesitate to freeze its dividend even as it experiences high earnings growth rates. That fact would likely make Mastercard somewhat irritating to own from a dividend perspective during a period of high inflation, but would likely be satisfying from an owner's perspective during a period of high inflation because the earnings would be advancing upwards.

Disclosure: I am long XOM, BP, COP. 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.