The Importance of Dividends
Core Holdings
My Updated List of Top 10 Super Companies
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I often get asked if investing exclusively in dividend-paying companies will bring the best results. There is no simple answer, but history shows that dividend income is an important part of your total return when investing in common stocks. Increasing stock prices help build your wealth and beat inflation, but dividends provide a steady return on your investment through thick and thin.
I also receive questions from investors asking me to compile a list of stocks to begin building their initial portfolios. Whether you are a new investor or an experienced pro, or whether you are young or old, I usually advise that you include some ultra-conservative dividend-paying stocks in your portfolio. I call them core holdings. Owning these conservative stocks will not only allow you to sleep at night, but will also provide you with modest appreciation and dividend income for many years into the future.
Dividend-paying stocks offer two ways to make money: The price of your stock can appreciate and the dividend can provide income. Invest in companies with histories of well-founded growth that will continue during the next several years and even decades. A company’s history of steady sales and earnings growth will usually lead to relatively steady appreciation and frequent dividend increases.
Dividends are the regular cash payments that a company sends to you or to your brokerage account. You can, however, instruct the company or your broker to reinvest your dividends into additional shares or fractional shares. Reinvesting your dividends makes sense, because the effects of compounding your dividends will make your investment grow even faster.
Many investors focus exclusively on speculative gains (appreciation), going so far as ignoring dividend payments when checking stock market results over long periods of time. You might be pleasantly surprised, though, if you include your dividends in your total return calculations, you will see that your returns are better than you thought. You will also find that dividend-paying stocks tend to decline noticeably less in market declines like we’ve been experiencing, than stocks paying no dividends.
Dividends are the payments of a company’s hard-earned profits. A company’s ability to continually pay dividends provides concrete evidence that the company is performing well. And accounting malfeasance is harder, or impossible, if a large transfer of cash is going to shareholders on a regular basis. I don’t recommend that you buy companies paying really low dividends; I only recommend companies paying dividends yielding more than 1% per annum (calculated by dividing the annual dividend by the current stock price).
There is another consideration when you’re evaluating dividends and yields: dividend payout. The dividend payout is the ratio of dividends per share compared to earnings per share (DPS divided by EPS). The payout ratio indicates if earnings can support the dividend. A growth company that pays a small dividend will tend to have a lower dividend payout ratio than a well-established “blue chip” company that has a higher dividend payout.
As a general rule of thumb, most successful dividend investors avoid companies with a dividend payout ratio above 50% or 60%. Anything above that mark means the company may not be investing enough capital back into the organization. Even if a company’s growth has slowed, it’s still critical that it reinvest a portion of its earnings back into the organization.
My top 10 “super” companies listed below offer dividends averaging 2.5%, which exceed the current 10-year U.S. Treasury bond rate of 2.0%. In addition to generous dividend payments, investors can expect steady long-term earnings and dividend growth of more than 10% per year. All of the companies maintain strong balance sheets with low debt and lots of cash. Annual dividend increases are common for all of the companies and have averaged 16% annual increases during the past five years.
The average dividend payout ratio for our 10 companies is 31%, which is well below our 50% to 60% limit. And best of all, investors have neglected high-quality companies during the past several years so that now these companies sell at very reasonable prices.
In my opinion, the following companies should be included in your portfolio:
Abbott Laboratories (ABT)
produces a wide range of drugs, diagnostic products, medical testing products, test analysis and nutritional products. Sales and earnings growth have been aided by expanding international sales and by recent acquisitions. Sales, earnings and dividends increased 8% to 10% during the past 10 years. We believe future growth will be the same or slightly better based on rising international sales, growing sales to the aging U.S. population and new acquisitions. ABT shares are undervalued at 11.6 times current EPS. Dividends have been paid since 1926 and currently provide a yield of 3.8%.The debate in Washington on what to do with the healthcare plan has placed a cloud over drug makers, which has no end in sight. Drug stocks, in general, have lagged the stock market, but lately investors are beginning to notice their low P/Es, high yields and steady earnings growth. Leading drug stocks, such as Abbott, should move substantially higher during the next 12 months.
Caterpillar (CAT) is the world’s largest manufacturer of earth-moving equipment. The company’s machines are used in mining, logging and farming, and in the construction, petroleum and transportation industries. Financial results for the second quarter were muted by parts shortages stemming from the disaster in Japan. However, during the remainder of 2011 and well beyond, demand for Caterpillar equipment will be especially strong as a result of the need to replace aging construction equipment.
Demand for additional equipment to rebuild extensive areas of the U.S. affected by recent tornadoes, floods and hurricanes will also increase. In addition, highways, bridges, etc. in the U.S. and other developed countries are in dire need of refurbishing and improvement. Finally, the rapid development of infrastructure in emerging countries such as Brazil, China and India provides a bright outlook for Caterpillar for an extended period of time. CAT shares are undervalued at 13.7 times current EPS. Dividends have been paid since way back in 1914 and currently provide a yield of 2.2%.
Chevron (CVX)
is the third largest global integrated oil company and has interests in exploration, production, refining, marketing and petrochemicals. The company has grown rapidly during the past decade after mergers with Texaco, Unocal and other companies. Chevron’s recent acquisition of Atlas Energy will provide the company with an industry-leading position in the lucrative Marcellus Shale natural gas area of Pennsylvania.Chevron’s development of a huge find in the Gulf of Mexico could add production growth of 1% during the next four years and 4% growth during the following four years. Additional finds off the coasts of China, Liberia, Turkey and Australia will also add significant revenues and earnings in future years.
Revenues increased 19% and EPS soared 69% during the past 12 months, boosted by increased oil and natural gas production and higher oil prices. We expect sales and earnings growth of 10% or higher during the next several years, depending on oil prices and production in the Gulf of Mexico. CVX is undervalued at 8.5 times current EPS. Dividends have been paid since 1912 and currently provide a yield of 3.2%.
Walt Disney (DIS) is one of the world’s most-recognizable names. The leading entertainment company operates a multitude of giant theme parks and resorts around the world as well as a cruise line, television networks, and movie studios. Disney recently opened a new resort in Hawaii and is building a new resort in Shanghai, China. Expansion is also in the works at its ESPN network, Disney World in Orlando and Disneyland in California.
Disney’s well-diversified holdings in the U.S. and overseas helped the company avoid a significant downturn during the recent recession. During the past 12 months, sales increased 5% and EPS rose 15%. We expect Disney to pick up the pace and produce sales and earnings increases of 9% and 23% respectively during the next 12 months. Expansion and recent rate hikes at the company’s parks and resorts will spur EPS growth. DIS shares are a bargain at 13.5 times current EPS. Larger box office sales and price increases could cause our estimates to be conservative. Dividends have been paid since 1957 and currently provide a yield of 1.2%.
International Business Machines (IBM)
is the world’s largest information technology company. IBM is taking advantage of increasing demand for software services from overseas corporations, which make up 65% of total sales. Revenues, earnings, and dividends increased 5%, 10% and 15% respectively during the past 10 years.IBM’s revenue from cloud computing will likely double in 2011 and increase substantially again in 2012. Revenues from Brazil, Russia India, and China will likely increase 25% or more this year, as well. IBM’s total sales, EPS and dividends will rise by 10% to 12% or more during the next five years. The company is well-positioned to take advantage of the current hardware and software cyclical upswing. IBM shares are reasonably priced at 13.8 times forward EPS. Dividends have been paid since 1916 and currently provide a yield of 1.8%.
Microsoft (MSFT) is the leading maker of software, primarily because of its dominance in desktop computer operating systems and office productivity products. The company’s Windows operating systems run more than 90% of all personal computers throughout the world. MSFT’s server software products are used in 70% of all computer server systems.
Microsoft has two relatively new product lines: cloud computing and video games. Cloud computing, which provides computing and storage on the Internet, is gaining in popularity, and the company has become one of the leaders. Video games have become big business, and Microsoft has become a leader with its Xbox video game system and accessories. The company recently introduced Kinect to compete with the popular Wii and Playstation Move games. Kinect is based on a webcam for the Xbox console and enables users to control and interact with the Xbox 360 without the need to touch a game controller. The player uses gestures and spoken commands to control a variety of games.
The software giant continues to spend heavily on research and development to maintain its front-running positions in the technology sector. Sales increased 12% and EPS soared 28% during the last 12 months--quite remarkable for a company with $70 billion in annual sales. Analysts are forecasting a sales gain of 12% for the next 12-month period and an increase of 10% for earnings per share. But not us. We believe Microsoft will produce substantially better earnings growth during the next 12 months which will drive its stock price considerably higher. MSFT shares are clearly undervalued at 9.9 times current EPS. Dividends have been paid since 2003 and now provide a yield of 2.5%.
PepsiCo (PEP) is a global leader in the soft drink and snack food industries. The company is expanding in international markets and focusing on health and wellness beverages and foods. Annual revenues, earnings and dividends increased 8%, 11% and 13% respectively during the past 10 years. We expect Pepsi to increase sales, earnings and dividends 10% or more during the next five years. New products and further expansion into emerging markets will spur future business. PepsiCo’s purchase of Wimm-Bill-Dann, a leading Russian dairy company, will diversify its product portfolio and extend its global reach. The stock is reasonably priced at 15.7 times current EPS. Dividends have been paid since 1952 and currently provide an attractive yield of 3.3%.
TJX Companies (TJX) is the largest U.S. retailer of discount apparel and home fashion goods with 2,700 stores in the U.S., Canada, Germany, Ireland and the United Kingdom. The company’s main chains are T.J. Maxx, Marshalls, Winners and HomeGoods.
Management is taking advantage of the slow economic environment by offering low prices and good-quality merchandise to attract new customers and retain existing customers. We expect TJX to retain its new-found customers and expand its store base aggressively during the next couple of years. Sales and earnings have increased impressively at a 13% rate during the past 10 years while dividends have been raised 22% per year.
Sales and EPS will likely increase by 7% and 19% respectively during the next 12 months and continue strong thereafter as new stores generate more sales and become more profitable. TJX shares are undervalued at 15.6 times current EPS. Dividends have been paid since 1980 and currently provide a yield of 1.5%.
Walgreen (WAG), a leading drug store retailer, is adding worksite and homecare services to its pharmacy business. The company has also become more active in acquiring small competitors. New management is renovating existing stores and cutting operating costs.
The company is once again delivering solid financial results after weak sales and earnings during the recent recession. Now same-store sales are up, and Walgreen is gaining market share. Walgreen is an excellent company to hold for long-term investment, because the company has produced very steady sales, earnings and dividend growth for the last several decades. The future for the drug store industry looks bright with the burgeoning population of baby boomers needing more and more drugs, medicines, etc.
Sales, earnings and dividends increased 13% to 14% per year during the past 10 years. We foresee similar growth during the next five years. New acquisitions and the expected rapid growth of the drug store industry will spark strong results. WAG shares are reasonably priced at 14.3 times current 12-month earnings per share. Dividends have been paid since 1933 and currently provide a yield of 2.6%.
Wal-Mart Stores (WMT)
is the world’s largest retailer with 9,000 stores, two million employees, and $430 billion total sales. The company’s stores offer low retail prices and one-stop shopping with groceries now accounting for 51% of sales. Sales and earnings increased 12% while dividends were generously increased 18% per year during the past 10 years.Wal-Mart is focusing on expanding in China, where the company’s square footage has risen 33% per year since 2007. Wal-Mart currently has 350 stores in China with plans to expand to 2,000 or more stores in the future. Management has set out a plan to re-focus on everyday low prices and compete head-on with dollar stores; offer a larger assortment of goods; remodel the layouts of stores; and improve Internet buying for customers. The moves should attract new customers and former customers looking for bargains.
Wal-Mart is opening 300 smaller Wal-Mart Markets and Wal-Mart Express stores. The move will enable the company to expand into new rural and urban areas. We expect sales and earnings to increase 10% per year and dividends to advance 12% per year during the next five years. WMT shares are undervalued at 12.1 times current EPS. Dividends have been paid since 1973 and currently provide a yield of 2.8%.
I will continue to follow these top 10 “super” companies, and other blue-chip, high-quality companies in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will focus on undervalued Canadian stocks. I hope you won’t miss it!
Sincerely,
J. Royden Ward
Editor of Cabot Benjamin Graham Value Letter
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