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Internal Compounding Provides Real Income, Too

|Includes: Roper Technologies, Inc. (ROP)
Summary

Dividend Growth investors may not recognize the income generating potential of low-yield stocks.

A company that excels at the internal compounding of its earnings provides opportunities to generate substantial income for its stockholders.

One investor traded shares in Roper Technologies over a 10-year period to generate both income and portfolio value.

In 2015, I wrote an article for SA that explained how internal compounding of earnings by a company can provide real income to even dividend growth (DG) investors. I used an actual 10-year trading history of shares in Roper Technologies (ROP) as a case study. Roper has been one of the very best allocators of capital over its history. Despite paying a dividend and raising it each year for 25 years, its dividend yield has never been high enough to attract attention from most DG investors.

Since my original article is now behind the SA paywall and not available to many SAers, I am reprinting a portion of it as a blog article for the benefit of any SAer that may find his or her way to my blog. Here is the “Cliff’s Notes” version:

I propose that DG investors in any phase who haven't already done so consider lowering their yield threshold and broaden their horizons and seriously consider companies with rather anemic dividend yields - or, perish the thought, no dividends at all. An objection to my suggestion could reasonably be made based on a preference for regular, more dependable cash dividends coming directly from the company over cash profits obtained from often fickle, undependable Mr. Market. I understand that.

Some investors don't even consider as income realized capital gains, calling the entire trade simply a liquidation of an asset. The logic: once sold, the shares no longer produce dividends and so dividend income is reduced. This ignores the fact that the profits realized from a cash sale can be used to buy shares in other dividend paying companies, a car, a house, a diamond, or a trip around the world - all purchases that would otherwise require dividends for funding - while retaining the amount of the original investment.

A singular focus on dividend yield overlooks the very real benefits to the investor of a company's internal compounding of reinvested cash flow at higher rates of return and greater leverage than the investor himself can obtain from reinvesting his dividends. If (notice the word "if") the company can generate consistently exceptional returns on the greenest dollars it retains, those growing earnings will increase the intrinsic value of the company commensurately, whether the company pays a dividend or not. The intrinsic value will ultimately be reflected in the price of its shares. Granted, the word "ultimately" admits to swings in the interim that some believe make such a company a "risky" investment. And yet, some DG luminaries claim that volatility and beta does not imply risk. With that I agree.

In this article, I hope to show investors how harvesting capital gains from companies whose yields don't measure up to their traditional thresholds can enhance their ability to achieve their goals ahead of their expectations. It is not my intent to change one's behavior in any drastic way or send them so far out of their comfort zone that they can't sleep well at night. I want only to make a case for an approach to investing that has served some investors extremely well, even those well along into a retirement where their main source of income has been income from their investments.

An example from one man's investing journey might help:

Roper Technologies Inc. (NYSE:ROP)

The investor bought his first shares of Roper Industries (the name was changed to Roper Technologies in May 2015) in 1998 in a tax-deferred rollover account. This analysis covers the 10-year period beginning on May 13, 2005 through May 15, 2015.

Roper is a global, diversified company with operating segments in medical and scientific imaging, RFID communication technology (think toll tag systems, for one application), industrial technology like pumps and flow measurement, and energy systems and controls. At the time he bought his first shares, ROP was concentrated in industrial technology, but has since, through numerous acquisitions, diversified into the three other segments, each of which is now larger than the flagship segment.

Roper's strategy is to limit its acquisitions to well-managed companies with strong positions in niche markets where there are opportunities for growth. In the company's 2015 annual report, Roper's CEO described the strategy this way: "Our high-performing businesses generate substantial free cash flow that we deploy to acquire additional high-performing businesses that generate additional free cash flow. This creates a "compounding effect" that drives long-term value creation."

According to its 10-K reports, ROP recorded 2014 net earnings of $646 million on net sales of $3.549 billion, a very respectable net profit margin of 18.2%. Ten years earlier, ROP's 2004 net earnings were $93.8 million on net sales of $969.7 million, a net margin of 9.6%. Over the 10 years, earnings showed a CAGR of 21.3%; sales grew at a 13.9% rate, dividends at a 16.9% CAGR.

This article is less about ROP than it is about how the investor managed his position over the past 10 years. The following table presents the starting point and the current status of his position:

(in $s)

Date

Price

Shs Owned

Mkt Value

Ann'l Div.

Yield

Div. Income

5/15/05

34.50

300

10,350

0.21

0.60%

63.00

5/15/15

174.17

400

69,668

1.00

0.57%

400.00

Respectable as the performance was, the table doesn't tell the whole story. By increasing his investment incrementally and then harvesting capital gains, the investor increased the amount of cash he could realize from a low-yield position. Because the company successfully executed its strategy of internally compounding its cash flow, he was able to generate significantly more cash than the dividend yield would suggest.

The following table breaks down the investor's trades (there weren't many) over the 10 years:

(in $'s)

Date

Quantity

Price

Amount

Tot. Invested

Shares Held

Mkt Value

Start

300

34.50

10,350

300

10,350

5/01/06

Buy 200

47.87

9,596

19,946

500

23,945

1/02/08

Buy 200

61.50

12,320

32,266

700

43,050

1/17/08

Buy 100

50.00

5,020

37,286

800

40,000

9/22/10

Buy 200

64.11

12,829

50,115

1000

64,110

8/08/11

Sell 400-

68.00

27,192-

22,923

600

40,800

10/4/11

Buy 200

65.00

13,007

35,930

800

52,000

5/04/12

Sell 100-

99.96

9,988-

25,942

700

69,972

8/01/13

Sell 150-

127.59

19,131-

6,811

550

63,795

6/11/14

Sell 150-

145.29

21,786-

14,975-

400

58,116

End

400

174.17

14,975-

400

69,668

The trading history reflects an increase in the investor's cash investment over the initial 5-year period. A year later, with the share price double what it was six years earlier, he recovered a little more than half of his invested dollars. Buying back half the shares a few weeks later when the share price dipped reflects a rethinking of the scale of his recent sale and reveals that the sale wasn't a "forced sale." Since then, as the share price has continued to climb, the investor has continued to harvest gains, all the while maintaining a respectable position in the company, a position substantially greater than it was in 2005.

Even though the share count came down 60% from its 2010 peak, from 1000 to 400, the investment value increased. Better yet, in 2010, ROP paid a $.095 per share quarterly dividend, or $380 annually on 1000 shares, while the investor's current 400 shares are paying $400 in dividends in 2015.

In addition to the $14,975 of realized capital gains, the investor received dividends totaling $2,872 over the period for a total cash profit of $17,847. The investor's time weighted average investment over the 10 years was approximately $24,000; his cash profit including dividends (not his total return) on his average investment was 74% of his average cash invested.

For those who don't consider harvesting capital gains as "real income," please note: if in 2005 the investor had invested $24,000 in a 10-year bond paying 7.4%, the "real income" coming back as interest would have been the same as his total cash profit from his investment in ROP. The difference is that the bond would at maturity give him his $24,000 back, which he could reinvest or do with as he pleased, whereas the ROP transactions gave him all his money back and left him with $69,000.

(Note as of August 28, 2019: those shares are worth a little more than twice as much. I sold 50 shares )

To maximize the opportunity to harvest cash as outlined in the article, the investor may need to look beyond his usual suspects. Looking outside the S&P 500 makes it somewhat more likely to find solid, growing companies trading at a more reasonable price. I've never had to look beyond the standard edition Value Line universe of 1800 companies to find ones that successfully compound their cash flow to grow earnings and dividends simultaneously.

What to screen for? I recommend starting with companies whose sales and earnings growth rate is above 8% and whose returns on equity and on tangible assets are north of 15% and stable or growing. In addition, profit margins should be growing on the higher sales base. The company should be a business that has room for continued growth, either because of its skill at making accretive acquisitions, its ability to expand its sales organically by entering new markets or introducing new products, or all of the above. Debt should be modest so that debt service doesn't present competition for dividend increases. As always, using common sense due diligence to understand the business and its qualitative and quantitative factors should be conducted once a suspect has been identified.

Companies that fit that description don't usually come cheap, but can often be acquired with trailing twelve-month earnings yields of 5% or better. Said another way, you don't have to resign yourself that you'd have to pay more than 20 times last year's earnings and you don't have to look for recent IPOs or technology companies.

As always, whatever the dividend yield, confine yourself to businesses you would love to own all of, if you had the resources to do so. Even if you don't expand your selection list, be open to developments in your own portfolio that present opportunities to harvest unexpected gains that the market presents you.

Disclosure: I am/we are long ROP.