This article is in response to Mr. Brian Grosso's article entitled "Dividend Growth Investors, Wake up!" In it, Mr. Grosso generalized that many if not most dividend growth investors ignore valuation and focus too heavily on large cap stocks. I also got the sense that Mr. Grosso does not comprehend the dividend growth investing strategy. He himself stated that he has warmed up to dividends. I get the impression this is much like someone warming up with their morning cup of coffee. I do not think he has drunk enough coffee yet to wake up and comprehend the actual purpose dividends play in dividend growth investing. It may have something to do with the impression I got while reading his article that, although it was not written, he is growth or total return oriented and enjoys receiving dividends if his investments provide one. He acknowledges their importance but fails to recognize why they are the basis of dividend growth investing. Finally, Mr. Grosso encourages dividend growth investors to move towards small cap stocks that pay dividends and offers investors a few "new" ideas. I am going to take the opportunity to expound on some of the written and unwritten points offered by Mr. Grosso.
What is Dividend Growth Investing?
This is almost an impossible question to answer because everyone is capable of practicing it in their own way. The basic premise is that dividend growth investors invest in companies that pay and grow their dividends annually and hold on to their shares for many years in order for compounding to take effect and grow their wealth. Most dividend growth investors have as their ultimate goal to replace their salaried income with dividend income to fund their retirement needs. Therefore, dividend growth investing has in many of its aspects a long-term objective.
I want to break the term "Dividend Growth Investing" down into its individual words. Dividend, Growth, Investing.
First, Dividend. Is it any wonder why the word dividend is first in this combination? The focus is on dividends. Dividends and not capital appreciation is the primary focus. Please note that I did not say that capital appreciation didn't matter; rather, it is secondary. The dividends received from investments is cash in the pocket. There is no need to sell any shares in order to receive it and one can even DRIP those shares to acquire more dividends in the future.
Second, Growth. Growth is an adjective for dividend. Dividend growth investors are not interested in just receiving a dividend. They are interested in dividends that grow each and every year. Usually, dividend growth investors are looking for a growing dividend that covers inflation and then some. Growth in this sense is not tied to capital appreciation. Although one can argue that it indirectly is since a company that can afford to grow its dividend should be generating sufficient earnings to do so. These increasing earnings usually lead to higher stock price appreciation. Many dividend growth investors have their own rules or guidelines for the amount of growth they are seeking and what they will do if that growth stops. So not only are dividend growth investors interested in dividends, but they closely watch for that raise.
Third, Investing. To me this definition from Investopedia describes investing in the dividend growth investing context perfectly.
Investing is the act of committing money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit.
Dividend growth investors have the mindset of being owners of a business. As owners, this usually means that they are invested for the long term to see the company prosper. Investing can build wealth but the simple act of investing is not enough to build that wealth. Investing will build wealth if it is done wisely.
Large Cap Orientation
This last sentence leads me to my next topic and one that Mr. Grosso emphasizes. I believe that my last paragraph explains why dividend growth investors lean towards large cap stocks. Large caps are stable and well established companies. They offer products and services that millions if not billions of people use around the world and will likely continue to need and use into the foreseeable future.
Here are some words that I thought would use to describe why dividend growth investors would lean to large cap stocks.
These type of stocks allow investors to sleep well at night. There is little concern that the company is going to announce something catastrophic. There is little concern that on the morrow the company's products are no longer going to be in demand. Think of Proctor & Gamble (NYSE:PG). People are going to continue to wash themselves and their clothes. People are going to put diapers on their babies.
These companies also have a lower beta. This means that as the market moves, the stock may move in the same direction but not as far. This translates into reduced volatility in the portfolio and possible capital preservation if dividend growth investors ignored valuation as Mr. Grosso claims they have a tendency to do.
There is also less action in their share prices. The shares in large cap companies have such large volume that the stock price won't be as heavily affected by sellers unlike small caps with lower volumes. For example, here is a picture of Johnson & Johnson's (NYSE:JNJ) stock price action versus MIND C.T.I., Ltd. (NASDAQ:MNDO) which is one of Mr. Grosso's suggested "new" dividend growth stocks.
One of the things you should notice is that MNDO is much more volatile. It has an average volume in the hundreds of thousands while JNJ has an average volume in the millions. Also, in just under a year and half, MNDO's stock price has tanked 50%. JNJ didn't drop nearly as much even during the great recession. I will note that Wal-Mart (NYSE:WMT) nearly dropped 50% in 2015 as a rare example. I am conscious that it does occur, even among the large caps.
Large caps are part of a risk management strategy within a portfolio. Sure the large caps are not likely to see double-digit growth anymore but as long as the growth continues to add to their already large cash generation that can continue to increase and pay dividends, large caps will speak peace to dividend growth investors. Overall, large caps bring peace or stability and remove costly emotional actions.
People tend to like dependability. Trust is implicit. Retirees are looking for that dependable income in order to enjoy their golden years. To demonstrate dependability, I am going to compare MNDO's annual dividend history to Coca-Cola's (NYSE:KO) and ask readers: which one would they choose?
Note: KO's dividends were adjusted for the 2012 2:1 stock split. Source: KO data from Coca-Cola.com, MNDO data from Nasdaq.com, chart created by the author.
I think the answer is clear. KO has been a dependable dividend grower for not only the past 10 years but the past 54 years! You can count on a raise occurring every March. I believe this also returns to the point of G which is growth. KO's dividend has grown whereas MNDO has risen but has been cut often enough as well.
KO's cash flow is dependable which allows for consistent dividend increases whereas MNDO as a micro-cap has inconsistent cash flow as it continues to grow its business and establish itself.
One thing I will also mention that I relate with dependability is the importance management places on dividends. For example, KO shows their dividend history on their website. MNDO sends you to NASDAQ.com to go find their dividend history. Two different attitudes regarding the dividend. In this sense, management appears to take ownership of the dividend. It has a place within the culture of the company. Barring some catastrophic event, each management team is likely dependable in ensuring the dividend policy continues to grow each year.
There are several points that I agree on with Mr. Grosso. There are some dividend growth investors that do buy their favorite stocks despite the valuation. That is their prerogative. I for one emphasize valuation and advocate patience for pullbacks. My recent articles (here and here) touch on the point of valuation. I know that I am also not alone on this subject.
I also agree that dividend growth investors, perhaps more so the younger ones, could consider companies from other market caps. These smaller cap companies may have their place in one's portfolio. Personally in my plan, I will look into them and buy them if they meet a certain criteria such as dividend growth and sustainability.
Mr. Grosso does raise an interesting idea. But there must be other companies who are challengers and contenders (to use David Fish's language) who will become the next dividend champions and that are smaller caps. These companies still have room to grow and pay larger dividends than the large or mega cap stocks. Due to the size of large and mega cap dividend growth stocks, there will come a time when their dividend increases are going to decline. PG and WMT are perfect examples as both have raised their dividends by about 2% each for the past few years. But think about it, PG and WMT were small before they became big, right?
Are there any consistent dividend growers among the small, micro or nano caps?
I am presuming that Mr. Grosso likes the smaller cap stocks because of their growth potential. I think companies with growth potential are good and important because it can fuel higher dividends. I do not think that Mr. Grosso's examples of MNDO and Conrad Industries (OTCPK:CNRD) will meet the criteria of dividend growth investors and were not the best examples. But, in order to explore the idea about smaller cap companies that pay consistent and growing dividends, I turned to the primary source of dividend growth stock ideas, the CCC list prepared by David Fish.
In David Fish's CCC Workbook, I turned to the All CCC tab. Column AG is where the market cap of each company is found. I manipulated the spreadsheet by inserting a new column and then writing out a nested If statement. Here it is, below, so that you can copy and paste it into your own spreadsheets for future reference. I used the market cap classifications from Finviz.com:
I then tabulated the results. Here is the breakdown of the CCC list by market cap.
Source: Chart created by the author, data from dripinvesting.org
Unless you knew the CCC list front and back, you may be like me and be surprised at the number of stocks outside of the large and mega cap classifications. I suggest to you that the "new" dividend growth investing source for "new" dividend growth stock ideas is still the old source (what is old is once again new!). Here are a few "new" ideas for you to consider that dividend growth investors would have more confidence in.
There is a total of 10 nano cap stocks. They happen to all be financials. One really stands out to me and that is Commercial Bancshares, Inc. (OTCPK:CMOH) which has paid a consistent dividend for 5 years, has a current dividend yield of 2.90% and a payout ratio of 26.9%. The dividend growth rate has been excellent. The 1-year DGR is 23.9%; 3-year is 19.6%; 5-year is 15.9%. It is rare to see this upward dividend growth trend which is one of the reasons why it caught my eye. CMOH currently trades at a P/BV of 1.6 and a P/TBV of 1.6 suggesting that CMOH is overvalued at this time.
There is a total of 76 micro-cap stocks. These are a little more sector diversified but the majority are still financials. Armanino Foods of Distinction (OTCPK:AMNF) has paid a dividend for 10 years. Its dividend yield is 3.60% with a payout ratio of 58.9%. The dividend growth rate has been declining but is still at double-digit growth (1-year = 10.6%, 3-year = 15.0%, 5-year = 17.2%, 10-year = 13.8%). AMNF trades at 17.6x current earnings and has a P/FCF of 22.4 suggesting that the stock may be overvalued at this time.
163 small cap stocks are among the CCC list. This group is far more diversified and has several interesting prospects. Altrion Corporation (NASDAQ:ATRI) is a medical instruments manufacturer. ATRI is a dividend contender having paid a dividend for 13 consecutive years. Its DGR has been exceptionally consistent with the 1-year, 3-year, 5-year and 10-year dividend growth rates ranging between 18.7% and 16.2%. Thankfully, the former was the most recent increase showing a growing dividend. The stock does only yield 0.99% but has a payout ratio of 22.7%. Shares are currently considered overvalued with a current P/E of 27.7, an EV/EBIT of 18.6 and a P/FCF of 28.4. I should note that despite the stock being a small cap its current price is $427.08. The following chart shows just how impressive the capital appreciation of this company has been.
Dividend growth investors focus primarily on dividends and the growth of those dividends. Large cap stocks have demonstrated a strong tendency to pay dependable dividends and reduce volatility in one's portfolio. Some dividend growth investors may have been reluctant to follow Mr. Grosso's suggestion to look for companies outside of the large blue chip stocks. Some of these reasons could include increased volatility (which could be difficult to manage emotionally), greater uncertainty about the dividend and whether retired investors can depend on its continued growth year after year, shifting priorities for the company as they continue to grow, etc.
Perhaps dividend growth investors could enjoy both types of growth: dividend and capital appreciation. Dividend growth investors have an opportunity to investigate and consider some smaller cap stocks that could bring higher growth than large caps while at the same time have some evidence that these same companies have management teams that have or will establish a fairly dependable dividend policy. Of course, there are increased risks with these companies into capital losses, dividend cuts and greater volatility. Each investor should first consider whether these kind of stocks fit in their investor type profile as well as their portfolio plan.
I welcome your comments regarding why you choose large cap stocks and perhaps if after reading this article you are more open to investing outside of those large cap stocks.
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Disclosure: I/we 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.
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