Does Your Dividend Portfolio Have Room For A Wild Child?

| About: Deere & (DE)
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If you invest with a strict portfolio-building objective to only consider buying ownership stakes in companies that will raise their dividends this year, next year, and every year after that for the foreseeable future, then the answer to my headline question is an easy no.

If you measure success in terms of constant linear dividend and earnings growth, then Deere (NYSE:DE) is not the stock for you. The dividend froze at $0.44 per share from 1998 through 2003.

And the business performance over the past fifteen years has fit the stereotype often associated with truly cyclical companies: booming growth in good times, and very steep drops in business performance during the not-so-fun parts of the economic cycle.

But the actual numbers mean more than my words, so let's take a look at exactly a "worst-case-scenario" looks like for investors that engage in buy-and-hold investing with Deere stock (as an aside, I know that some of you reading this consider it an oxymoron to use the term "buy-and-hold" in the same sentence as a cyclical company. For my investing purposes, I categorize cyclical companies into two categories-the buy-and-holds like General Electric, Emerson Electric, John Deere, and the oil majors that likely experience growth over each business cycle, and the buy-and-sell cyclicals like Alcoa and the car companies that pose a significant risk of treading water from one business cycle to the next).

Anyway, this is what a John Deere investor needs to prepare for:

  • (1) In 1998, John Deere posted $2.08 in profits while paying a $0.44 annual dividend, and the profits fell to $0.51 in 1999. And then profits fell to $0.32 in 2001, while the company was still paying a $0.44 dividend. The honest question this poses to you, the long-term investor is this: Would you be prepared to deal with at least 36 months of collapsing earnings that could conceivably cause profits to fall below the dividend payout? If you answer that question no, you should ignore Deere stock. There are a million ways to make money in this country, and nights are easier when you're building wealth in a manner consistent with your nature.
  • (2) As you probably already guessed, the company's profits took a tumble during the worst of the recession in 2008 and 2009. The company made $4.70 in profit in 2008, and it fell to $2.82 in 2009. As if seeing earnings fall in half weren't enough, the stock price also fell from a high of $94.90 in 2008 to $24.50 in 2009. You need to honestly consider whether you can deal with that kind of volatility with accompanying profit declines. Picture the scenario. Someone that bought 1,000 shares in 2008 would have seen his holdings generate $4,700 in total companywide profits trade at a total value of $94,900. At some point during the next year, those 1,000 shares would have been generating $2,820 in total companywide profits and would have only been worth $24,500. And the company still trades below those 2007 highs (although its profits have doubled since then). Only you can decide whether you have room for an at-times brilliant wild child in your portfolio.

Given the things that I have just mentioned, you might wonder: Why would I even consider John Deere as a potential investment in a world where we can just buy some Coca-Cola, buy some Colgate-Palmolive, and kick back and collect the dividend checks.

The reason is this: if you believe that the global economy will perform better over the next five to ten years than the gloom and doom that is regularly predicted, this company turns into a rocket ship of capital appreciation and dividend growth. It makes good profits in "normal" times like 2011, 2012, and this year. The "catch" if you will, is that if we have consistent economic recession, this company's profits and stock price will fall substantially, and a static dividend will be your best case scenario.

Take a look at this F.A.S.T. Graph, courtesy of Chuck Carnevale, to see what an investment in John Deere has done over the past ten years with dividends reinvested:

Every dollar invested in the S&P 500 on the last day of 2002 (with dividends reinvested) would have become $2.51. Every dollar invested in John Deere on that same date would be worth $4.44. A large-cap company that quadruples wealth in a decade is something deserves at least a cursory review. And despite the current yield of only 2.46%, investors today would be collecting ten cents in annual dividend income on every dollar they invested into John Deere at the onset of the 2003 year.

And plus, there are things you can do to mitigate the risks posed by owning a truly cyclical company as part of a permanent capital portfolio.

First, even though I mentioned that John Deere fell from over $94 in 2008 to under $25 in 2009, you can avoid this problem easily if you do not buy at the top of the economic cycle. In every year from 2002 to 2005, you had an opportunity to buy John Deere stock in the $20s. If you had been holding the stock for 3+ years by the time the 2008-2009 crisis came around, you would have actually broken even or been ahead on your position despite the superficial chattering among the stock-market cognoscenti about John Deere stock seemingly losing ¾ of its value. That pain would only be true if you bought the stock at the immediate, short-term high before the fall.

Secondly, I do believe the company is currently taking steps to moderate the effects of the business cycle by diversifying its operations across countries. I'll give an example to show you what I mean. In 1998, John Deere made $2.08 in total profits. By 2001, it was making $0.32 in profits. At that point in time, the company was very susceptible to the American economic cycle. That's why profits in 2001 were only 15% of what they were in 1998.

But by the time the 2008-2009 economic crisis came around, John Deere had been expanding its operations heavily to France, Germany, Canada, Mexico, South Africa, Argentina, Spain, and Brazil. When you diversify across countries, you can devote your energies to growing in countries that are at different points in the business cycle (even if the aphorism that "when America sneezes, the rest of the world catches a cold" is still true, that does not mean that every country's business cycle is affected in a congruent way). That's why profits only fell from $4.70 per share in 2008 to $2.82 in 2009. In 2009, profits were 60% of the 2008 high, which is a much better cyclical performance than the 1998 profits that were only 15% of what they were in 1998. As John Deere continues to diversify internationally, I think it may still be intelligent to plan for a 1998-2001 worst case scenario, but realistically expect a 50% drop in profits as the worst case scenario given its broader operational structure.

With John Deere, a P/E ratio analysis is not particularly applicable-cyclical companies are at the cheapest when their P/E ratio is high, and they are at their most expensive when their P/E ratio seems to indicate cheapness. Instead, I think of it like this: For a little over $80 per share, I can get my hands on something that will be making $8, $9, or even $10 per share in the coming 3-5 years if the economy improves, but it could fall to $5 or $6 per share in earnings if trouble shows up ahead. You have to plug in your assessment of impending economic recession into your calculations of intrinsic value with a company like Deere, and that is where the art of investing displaces the science of investing-or as the poet Jorge Luis Borges might put it, the fire becomes more important than the algebra.

I think investing in John Deere can be wise for long-term dividend investors if the following three elements are met for you:

  1. You already have a strong portfolio backbone with all of the usual suspects of companies that are reliable during a recession.
  2. You can handle the prospect of severe price declines and even dividend freezes if we enter a protracted recession.
  3. You believe the economy will be better in 2014, 2015, and 2016 than today. If you think things are going to get worse, you should be patient, as that would likely indicate a decline in Deere's price and earnings.

For dividend investors with a value or contrarian orientation, John Deere is one of the most provocative companies out there. While everything else is going up, John Deere is still lagging its 2007 highs. The operating margins have been on a steady, almost linear, uptick-raising from 7.9% in 2003 to 15.5% now. Only about one out of every five dollars that the company generates in profits are going towards the dividend. And that is especially impressive given that the dividend has almost quintupled since 2003. The market for high-horsepower tractors in Brazil is carrying the company, along with 8% annual growth from the Agriculture & Turf segment. The current share price does not reflect the potential of better economic times ahead, and that should draw in the attention of the enterprising dividend investor.

Disclosure: I am long GE, EMR. 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.