If You Believe In Dividend Investing, You Should Buy Cyclical Companies, Not Consumer Staples

by: The Independent Investor

Dividend investors are like an army. While the S&P 500 and its tracking exchange traded fund, SPY (NYSEARCA:SPY), has rallied over 20% from market lows of the summer of last year, and stock such as Apple (NASDAQ:AAPL) are up over 30% in the last year, the recent sell-off has been brutal.

Today, the S&P 500 is off by nearly 10% in the last month, but cyclical sectors such as the industrials, energy, and the financials, are own nearly 20% in the last two months. Many leading industrial and financial stocks such as GE (NYSE:GE) and Citigroup (NYSE:C), have sold-off nearly 20% in the last two months, despite recently reporting strong mid-single digit growth just two months ago. Leading energy stocks such as Chevron (NYSE:CVX) and Exxon-Mobil (NYSE:XOM) have also declined significantly in the last two months as oil prices have dropped nearly 30% since early March.

Still, dividend mutual funds and exchange traded funds have sold-off little during the recent sell-off. Indeed, many leading dividend and consumer staple stocks, such as Kimberly-Clark (NYSE:KMB), Wal-Mart (NYSE:WMT), Altria (NYSE:MO), and Costco (NASDAQ:COST), are at or near these company's one year highs.

Source: thestreet.com.

Obviously, many of the leading dividend stocks in many high-yielding mutual and exchange-traded funds, such as Kimberly-Clark and Wal-Mart, are not cyclical companies, and these companies' strong recent earnings reports suggests that these companies 'earnings will likely remain strong even if the growth outlook continues to deteriorate.

Still, a number of leading cyclical companies that have sold-off over 15-20% in the last several months, despite having solid balance sheets, such as GE, Boeing (NYSE:BA), and Chevron (CVX), are now yielding nearly twice the 10 year Treasury and as much as many traditional dividend stocks such as Wal-Mart and Kimberly Clark. Also, while Kimberly-Clark and Altria trade at around 14-15x an average estimate of next year's likely earnings, analysts are projecting mid-single-digit growth over the next five years for each company. While leading cyclical companies such as GE and Boeing are trading at 11-12x average estimates for next years likely earnings, and these companies are paying out strong dividends as well.

Obviously forward earnings for cyclical companies is always speculative. Still, companies such as GE and Boeing have consistently had strong earnings reports over the last several years, and few traders and investors are expecting another recession today.

The real value of dividend investing is compounding your annual returns by reinvesting dividend in strong companies at reasonable or cheap valuations. Dividend investing is not primarily about the yield. If you simply invest in companies that are overvalued, but have high strong dividends today, obviously your likely long-term returns will be limited even if the dividend is raised most years. The reason why the top performing stocks over the previous several decades have been Altria (previously Phillip Morris) Kimberly-Clark is because investors have been reinvesting dividends in these stocks as these companies have consistently grown at double digits. If you look at total returns offered by most dividend stocks without reinvesting the dividend, average annual returns drop significantly.

This exactly why I don't understand why dividend and income investors don't see that the exact reasons why the best performing dividend stocks have significantly outperformed most of the broader indexes supports investing in cyclicals today. Earnings growth and dividend growth are two sides of the same coin. Reinvesting dividends in companies with 5-6% long-term growth rates that are trading at 15x forward earnings estimates and yielding 3-4% offers minimal possible long-term returns. A company trading at 15x forward earnings that is is growing at 5-6% and yielding less than 4% is pricing in multiple future dividend increases today Likewise, investing in cyclical companies with strong balance sheets trading at historically cheap valuations with dividends of 3-4% enables an investor to reinvest dividends in a company that will likely grow its earnings and dividend payout considerably over the next several years.

To conclude, obviously cyclical companies will be dependent on an improving growth outlook over the next several years to continue to offer double digit returns. Still, while the economic environment remains weak and these companies have strong balance sheets and very low borrowing rates, reinvesting 3-4% dividend yields in companies with double-digit growth prospects that are trading at 8-12x very reasonable estimates of next year's likely earnings is a conservative way to both, collect income, and position your portfolio for the best possible future returns. While leading dividend and consumer staple stocks have been the best performing stocks over the last several years, the best value is often found in the most beat-up parts of the market.

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