Earnings Vs. Dividends: Which Is More Important?

Includes: AAPL, GIS, INTC, MCD, MO
by: Geordy Wang

In an article I wrote a couple of months ago about dividend investing, SA regular richjoy403 asked me to offer a little more insight into my own stockpicking strategies. I promised him that I would, though being the life long procrastinator that I am, it took eight weeks before I finally churned out a follow up article. Still, I've finally managed to whip one up - so this one's for you, Rich!

Let's take a step back for a second. One trait that I've noticed that's almost universally shared amongst dividend investors is a laser beam focus on rising dividends. This, of course, makes perfect sense: if your primary investment goal is to generate an income stream that grows at a rate which exceeds inflation every year, it would be counterproductive to invest in companies that freeze or cut their dividends. However, there are many companies out there that have maintained a history of increasing their dividends, though the tallies of some are more robust than others. In order to narrow our list of prospective stocks even further to zoom in on only those that are truly investment-grade, we must look beyond the dividend.

I've always believed that the logical next step is to look at earnings, and this is something that I practice with my own portfolio. When it comes to dividend growth investing, and indeed, investing in general, earnings growth and dividend growth are two sides to the same coin. Investors can only profit in the long term when both occur simultaneously. Earnings growth without corresponding dividend growth is just a bunch of numbers on a financial statement. Dividend growth without corresponding earnings growth is unsustainable, and is guaranteed to either terminate or reverse course over the long run. Therefore, the correct answer to the question in the title is hidden option C: "Stop asking me trick questions!"

Overweight Earnings Growth: Apple (NASDAQ:AAPL) in Profile

Whew, that was a lot to digest. So let's start with the first case. There are plenty of companies trading on the market today with zero yield, so obviously they have value even though there is no dividend growth happening. I happen to own Apple in my portfolio, which is probably the most well-known example of a tremendous success story that doesn't currently pay a dividend (though as of July this year that will no longer be the case). However, the purpose of any business is to generate money for its owners, and shareholders as a collective cannot possibly make money from a company until it initates a dividend. Yes, this includes even Apple. Apple shareholders have made a lot of money in the stock over the past decade, but all of it came from the pockets of other shareholders. Shareholders as a group won't realize a net profit until the company begins to return earnings to owners via a dividend.

So why own Apple, or any other zero yield equity? Because we trust the company to reinvest the earnings at an outsized rate of return and grow the business, which will lead to a higher dividend stream when the board finally decides to pay a dividend. It's all about deciding whether to get your payday now, or get a bigger one later - still, there needs to be a payday eventually. All companies will inevitably reach the point where they generate more cash than they need for operations and expansion.

With $100 billion in the bank and tens of billions more coming in every year, Apple has arrived at that point, which is why it makes sense for the world's most valuable company to initiate its first dividend since 1995. I bought Apple in the middle of June last year, and when I told people that my purchase was an income play, many called me crazy. After all, how can you buy a stock for the dividends when it doesn't pay any dividends? However, an integral part of my original investment thesis was the prediction that the company would initiate a dividend no later than one year after my purchase. As the months passed, I became more and more certain. The prediction was finally fulfilled with three months left on the clock. I was fully prepared to close out my position if twelve months went by with no sign of a dividend on the horizon, but now that's no longer necessary. With a buy-in price of $321.85, Apple's dividend will represent a yield-on-cost of 3.3%, creating a very respectable income stream on an original investment that paid no dividends, and backed by one of the strongest companies on the planet.

Overweight Dividend Growth: Altria (NYSE:MO) in Profile

However, there are many investors for whom zero yield equities do not fit their needs. They may require a steady income stream to help fund their living expenses, or they may simply wish to mitigate risk by investing in companies that have already demonstrated that they're looking after shareholder interests by currently paying a dividend. For such income-oriented investors, the second case described in the introduction is of paramount importance, where we must align dividend growth with earnings growth. We can't simply look at companies that have been raising their dividend for many consecutive years and judge them to be investment grade without also requiring a corresponding uptrend in earnings. The dividend increases may have been funded by a rising payout ratio, which would impose an inherent upper limit on the dividend growth rate because a company's payout ratio cannot possibly be sustained above 100%.

A key example to illustrate this point may be found in Altria, which is a dividend champion that has been extremely profitable to shareholders over the past half century. However, at its current price point, I do not believe that Altria represents an attractive investment. Any long term analysis of the company will be muddled by its 2007 spin-off of Kraft Foods (KFT) and its 2008 spin-off of Philip Morris International (NYSE:PM), but just looking at the trailing three years, Altria has increased its per share dividend from $1.32 to $1.58, for a 9.4% annualized raise. Sounds good, right? Not when you move on to examine its net earnings, which haven't budged at all. The company closed 2009 with normalized diluted EPS of $1.74, it went up to $1.89 the following year, and promptly dropped back down to $1.75 last year. Its dividend hikes were funded entirely from its inflating payout ratio, which has ballooned from 75% to 90%. Coupled with the macro headwind of a continuing decline in America's tobacco industry and the fact that the company is heavily leveraged with negative tangible book value, and suddenly 19 times earnings seems a mighty high price to pay for a slice of Altria.

Intel (NASDAQ:INTC): A Share Buyback Machine

A flat bottom line isn't necessarily a bad thing, because per share intrinsic value of a business can go up even when the business itself doesn't grow. The way this is accomplished is through effective internal share buybacks. One salient example of this maneuver in action is Intel, which I believe represents one of the more attractive income plays in the relatively low yield technology sector. Since 2000, Intel has increased its dividend from $0.07/share to $0.78/share. Obviously this rate of growth cannot be sustained since Intel's payout ratio at the turn of the millennium hovered just a hair above 0%, but investors should expect rising dividends going forward as long as EPS can be expected to go up. While Intel's net profit has grown from $10 billion to only $12 billion over the past 12 years, its diluted EPS has grown from $1.53 to $2.39. Intel pulled this off by aggressively buying back its own shares, reducing common shares outstanding from 6.7 billion to 5 billion. As a result, investors have experienced solid gains despite little movement on the bottom line.

However, I don't like to depend exclusively on buybacks. There's no guarantee that a company's stock will be available at fair value or below in the future, and a poorly timed repurchase can end up destroying rather than creating shareholder value, a la Netflix (NASDAQ:NFLX). Furthermore, buybacks have a hidden cost that's often unaccounted for: they drive up the intrinsic values of outstanding stock options owned by executives, which is money that comes out of the pockets of shareholders. Therefore, when I look for a true dividend champion, one that I'm willing to stake my financial future on, I absolutely must see growing profits as well as a growing dividend. There are two stocks I have my eye on right now that fit this criteria. I'm still waiting on a better entry price for both of them, so if they were microcaps, I wouldn't be talking about them until I'm finished building my position (hey, this ain't a charity). But when it comes to larger companies, a single article published on the web isn't going to move the needle at all. So let's get down to business.

Two Income Picks For 2012 And Beyond

The first company I'm looking at is McDonald's (NYSE:MCD), America's favorite fast food joint. The world is in awe of Apple, but the crew running Mickey D's has been executing just as well over the past decade. This story began when I happened to walk into a local McDonald's one day to leech their free wireless for my iPad. I think I may or may not have been writing an article for Seeking Alpha. By the time I left, I had devoured a double cheeseburger, a medium fries, a soda, and a slice of cheesecake, even though I went in there intending to purchase nothing. I skipped dinner that night, and spent the time thinking about what a bloody good business McDonald's was running instead.

What makes McDonald's such a fantastic dividend play is that it has not only been maintaining its massive streak of consecutive dividend increases, the underlying business has been growing like weeds under the leadership of CEO Jim Skinner. Net income has grown from $8.9 million ten years ago to a staggering $5.5 billion today. It hasn't posted a single year of decline other than 2007, which was attributable to a one time special charge due to the sale of its Latin America operations. The recession didn't even touch McDonald's. Its franchise-oriented business model has been a blowout success story, allowing McDonald's to grow at a rapid clip without tying up valuable equity capital, an advantage that's usually possessed exclusively by technology companies. Furthermore, despite its phenomenal success, McDonald's continues to innovate and use its restaurants as experimental environments to field test new ideas. Every month I walk into a McDonald's, I see something new and interesting on the menu. Some companies make you wonder how they became so successful. McDonald's isn't one of them.

My second favorite dividend stock pick is General Mills (NYSE:GIS). General Mills is the classic example of a boring stock. Its earnings go up like clockwork every year, as does its dividend. It doesn't expand at a fast enough pace to draw attention to itself, but its growth is steady and reliable. Over the past decade, earnings have grown from $665 million to $1.7 billion. Its dividend per share grew from $0.55 to $1.12. It didn't begin to increase dividends until 2005, so it hasn't joined the hallowed halls of dividend champions like McDonald's and Coca-Cola (NYSE:KO) yet, but I fully believe General Mills to be a champion in the making. Its brand portfolio is solid, backed with household names like Betty Crocker, Häagen-Dazs, Cheerios, Yoplait, Progresso, and Nature Valley. When I'm performing an equity analysis, I try to look beyond the financial numbers for qualitative advantages possessed by a company (otherwise we might as well let a stock screener do all the work). One such advantage for General Mills is an extremely strong corporate culture populated by very satisfied and committed employees. On Glassdoor.com, a site that ranks the best companies to work for based on employee reviews, General Mills came in 4th out of all companies in 2011 and 2nd out of all publicly traded companies, behind only Southwest Airlines (NYSE:LUV). And the best part is that rising commodity prices have temporarily depressed the company's profit margins, which has put enough pressure on its stock that it's now trading very close to my target buy-in price.

As a result of their exceptional earnings growth, shareholders of both McDonald's and General Mills have experienced tremendous capital gains as well as steadily rising income streams. Here's the ten year charts:

Lost decade? What lost decade? It's true that one of the major advantages of income investing is that dividends insulate you from market price fluctuations, so dividend investors need not worry as much about capital gains. However, as Benjamin Graham said, the market is a voting machine in the short run, but a weighing machine in the long run. If the intrinsic value of a company expands over time as the result of healthy business growth, not only will its dividend distributions increase, the price of the stock will go up as well. That's exactly what happened here for both companies.

In conclusion, earnings growth and dividend growth go hand in hand. A true dividend champion is one that has proven not only that it is capable of rewarding its shareholders with a growing dividend, but also that it can aggressively outmaneuver its competitors on the field and grow the underlying business that funds its dividend. Very often a dividend cut will be preceded by a drop in earnings or a capped out payout ratio.

This is especially important for a lot of dividend champions, which have built up a huge streak of dividend hikes by virtue of being very old companies. Oftentimes the managers who were responsible for the majority of the company's previous success aren't the same ones at the helm today. By staying vigilant and keeping an eye on important metrics that extend beyond the dividend, income investors can make sure that their managers are up to the task and vastly improve their chances of deploying their capital into only the highest quality businesses on the market.

Disclosure: I am long AAPL.

Additional disclosure: I may initiate a position in MCD or GIS at any time.