Why Dividends are Important
A Word on Core Holdings
My Top 10 Super Companies
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 to 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 old pro, or whether you are young or old, I usually advise that you include some ultra-conservative companies in your portfolio. I call them core holdings. Owning conservative companies 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. When asked how long an investor should hold a stock, Warren Buffett’s answer is: “Our favorite holding period is forever.”
Dividend paying stocks offer two ways to make money with your stocks: The price of the 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 faster.
Many investors focus exclusively on speculative gains (the appreciation), going so far as ignoring dividend payments when reporting stock market results over long periods of time. You might be pleasantly surprised, though, if you include your dividends when you calculate your total return. You will also see that dividend-paying stocks tend to decline noticeably less than stocks with no dividends.
Dividends are hard-earned cash, and a company’s ability to continually pay them provides concrete evidence that the company is performing well. Accounting malfeasance is harder, or impossible, if a large transfer of cash is going to shareholders on a regular basis. Don’t include companies paying really low dividends, because I am referring to companies paying dividends yielding more than 1% per year (calculated by dividing the annual dividend by the current stock price).
There is another common pitfall to be aware of when evaluating dividends and yields. 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 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 though a company’s growth has slowed, it is still critical to reinvest a portion of earnings back into the organization.
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10 High-Yield Winners for 2011
Did you know that dividend stocks have out-performed non-dividend stocks by four to one over the past 35 years?
That’s because dividends usually increase each year. In fact, more than 137 years of data point to the inescapable conclusion that owning dividend-paying stocks—and then re-investing those dividends—beats other investment approaches hands down.
And for a limited time, if you subscribe to Dick Davis Dividend Digest, you’ll receive our top high-yield picks for 2011!
My top 10 “super” companies listed below offer dividends, which on average, exceed the current 10-year U.S. Treasury bond rate of 2.5%. In addition to generous dividend payments, investors can expect steady long-term earnings and dividend growth of about 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 15% annual increases during the past 10 years.
We expect the size of dividend increases to diminish somewhat during future years. The average dividend payout ratio for our 10 companies is 36%, which is well below our 50% to 60% limit. And best of all, high-quality companies have been neglected by investors during the past several years and now 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 upon rising international sales, additional sales to the ageing population of America and new acquisitions. ABT shares are undervalued at 12.1 times current EPS. Dividends have been paid since 1926 and currently provide a yield of 3.3%.
Aflac (AFL) is the world’s largest supplemental insurance provider. The company derives 75% of its business from Japan, where it also sells life and health insurance. Sales have increased 10% to 12% per year during the past 10 years, and dividends have increased an impressive 22% per year. We forecast sales growth of 10% and earnings and dividend growth of 12 to 15% during the next five years. New products and an improving economy in Japan should produce considerable excess cash. AFL shares are undervalued at 9.6 times forward 12-month EPS. Dividends have been paid since 1973 and currently provide a yield of 2.2%.
Colgate-Palmolive (CL), a leading consumer products company, continues to benefit from a very successful restructuring program. Leading products include Ajax, Fab and Murphy cleaners, Colgate toothpaste, Irish Spring soap, Mennen shave cream and Hill’s pet food. Sales and earnings increased 7% to 9% per year during the past 10 years, while dividends were boosted 12% per year. Further success in Latin America, new products and new acquisitions will keep earnings and dividends moving forward at a 10% pace during the next five years. CL shares are reasonably priced at 14.6 times forward EPS. Dividends have been paid since 1895 and currently provide a yield of 2.8%.
General Dynamics (GD) makes electronics for land, sea and air weapons systems. GD manufactures cargo ships and Gulfstream business jets. It also makes armored combat vehicles, submarines and destroyers. The company sells primarily to the U.S. Department of Defense including the U.S. Army and Navy. General Dynamic’s sales, earnings and dividends increased 10% to 12% per year during the past 10 years. We expect sales and earnings to increase at an 8% clip during the next five years, but the company will likely increase dividends by 12% per year. Sales to the military will probably slow, but sales generated from General Dynamic’s other units, including Gulfstream, will likely pick up steam. GD shares are undervalued at 8.9 times 12-month forward EPS. Dividends have been paid since 1979 and currently provide a yield of 2.7%.
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. We expect IBM to increase EPS and dividends by 11% to 12% during the next five years. The company is poised to take advantage of the anticipated up-cycle in technology. IBM shares are reasonably priced at 11.6 times forward EPS. Dividends have been paid since 1916 and currently provide a yield of 1.9%.
Johnson & Johnson (JNJ) is the world’s largest and most diversified health care company. The company produces a large variety of drugs, medical and diagnostic equipment, and consumer products. After experiencing slower growth during the past couple of years, Johnson & Johnson is now focused on faster growing health care segments and on divesting underperforming divisions. Sales and earnings growth of 8% to 9% per year during the past 10 years was accompanied by 14% dividend growth. Acquisitions and new product introductions will help sales and earnings grow by 6% to 7% during the next five years. Dividends will probably increase 8% per year. JNJ shares are reasonably priced at 12.6 times forward EPS. Dividends have been paid since 1944 and currently provide a yield of 3.5%.
McDonald’s (MCD) operates 32,000 fast-food restaurants in 118 countries and generates $23 billion in sales. Sales in Europe have been surprisingly strong, while sales in the U.S. are not nearly as weak as other restaurants because Americans are eating at less expensive restaurants, such as McDonald’s, to save money. Sales and earnings increased 8% to 10% per year during the past 10 years, and dividends jumped 25% per year. We forecast sales, earnings, and dividend growth of 9% to 10% per year during the next five years. MCD’s ability to innovate ahead of competitors should keep growth intact. MCD shares are reasonably priced at 15.6 times forward 12-month EPS. Dividends have been paid since 1976 and currently provide a yield of 3.2%.
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%, 10% and 12% respectively during the past 10 years. We expect Pepsi to increase sales, earnings, and dividends by 10% to 12% during the next five years. New products and further expansion into emerging markets will spur future business. The stock is reasonably priced at 15.0 times next 12-month EPS. Dividends have been paid since 1952 and currently provide a yield of 2.9%.
Walgreen (WAG), a leading drug store retailer, is adding worksite and homecare facilities 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. Sales, earnings, and dividends increased 11% to 12% per year during the past 10 years. We foresee sales, earnings and dividend growth of 8%, 12% and 15% 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 14.5 times forward 12-month EPS. Dividends have been paid since 1933 and currently provide a yield of 2.1%.
Wal-Mart Stores (WMT) is the world’s largest retailer with 8,500 stores, two million employees, and $400 billion total sales. Groceries now account for 51% of sales. Shoppers seeking low retail prices and one-stop shopping are boosting Wal-Mart’s sales. Sales and earnings increased 10% while dividends jumped 20% per year during the past 10 years. 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 12.5 times forward EPS. Dividends have been paid since 1973 and currently provide a yield of 2.2%.
I will continue to follow my 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 stocks with low price-to-book-value ratios. I hope you won’t miss it!
J. Royden Ward
For Cabot Wealth Advisory
Editor’s Note: You can find additional dividend-paying stocks selling at bargain prices in the Cabot Benjamin Graham Value Letter. In every issue, you’ll find my legendary Maximum Buy and Minimum Sell Prices for over 250 stocks. Click here to get started today!