Sunday, May 12

Week 97 - Capitalization-weighted Index of 11 High-quality Dividend Achievers

Situation: What is a high-quality stock? Here at ITR, we advocate a “buy and hold” strategy of stock selection, our goal being to set up a dividend reinvestment plan (DRIP) for each selection. We advocate that you start small and add a little each month, by having that amount withdrawn electronically from your checking account. That means you've got a lot at stake if you change your mind about a stock and liquidate your DRIP. Before starting down that path, you need to have a definition of “quality” (there are many to choose from) that will let you get into a stock and stay invested for the long term.

We’ve offered some tips in previous blogs (see Week 3, Week 50, Week 72, Week 87 and Week 93):
   a) plan to have at least 4 DRIPs;
   b) avoid companies with long-term debt that is worth more than the stock;
   c) avoid stocks that have a 5-yr Beta higher than the S&P 500 Index's (1.00);
   d) favor companies that have positive free cash flow (FCF).

Recently, we’ve seen that a number of fine companies with positive FCF don’t have enough FCF to pay their dividend. That means they’ll have no Retained Earnings (RE) with which to fund next year’s growth, and the company has to raise more cash (sell more stock, issue more bonds, or lobby government officials to make more tax expenditures). Companies get caught in this bind for 3 reasons: 1) The economy is still in the Intensive Care Unit (so to speak): Revenues can’t generate enough FCF to afford the dividend policy that the company has trained its investors to expect (e.g. annual raises sufficient to cover inflation). 2) That dividend policy needs to remain stable when there is a slack economy, since it is an effective way to keep investors in the stock market given the paltry income they get from bonds. 3) Foreign earnings are difficult to repatriate because 20-25% will have to be turned over to the Internal Revenue Service (i.e., the difference between low tax rates in developing countries and high tax rates in the United States). For that reason, most companies reinvest earnings in the same country that produced the earnings.

Here at ITR, "High quality” means simply that the company has Retained Earnings at the end of the year. That's the essence of capitalism. Rational investors favor investment-grade bonds, since return of their original investment is guaranteed. There are no guarantees that a stock will retain value. Remember, the Central Thought of business isn’t to make money . . . it's to redistribute the risk of losing money. A stock investor holds out hope that her chosen company will grow in value by deploying Retained Earnings. Most companies don’t have Retained Earnings; they have to expand by issuing stocks or bonds which costs at least 8%/yr.

The accompanying Table was constructed from a list (see invescopowershares) of 201 Dividend Achievers, i.e., companies that have increased their dividends annually for the past 10 or more yrs. Those companies were screened as follows:
   1) Any company’s stock that had a total return during the Lehman Panic period (10/07 thru 3/09) worse than -30% (vs. -46.5% the lowest cost S&P 500 Index fund--VFINX) was discarded .
   2) Any stock that has a history of growing dividends less rapidly than 5%/yr, which is the dividend growth rate for VFINX, was discarded. 
   3) Companies with a dividend yield less than 1% were discarded. 
   4) Companies that don’t have an S&P stock rating of at least A-, and an S&P bond rating of at least BBB+ were discarded. 

The remaining companies were checked against the Buyupside website for performance vs. VFINX over the past two market cycles, beginning with the peak that occurred on March 24, 2000. Since then, VFINX has grown at a rate of 2.3%/yr through the reinvestment of dividends--price performance has only been 0.3%/yr. None of the companies that remained after applying the above screens performed as badly as VFINX, so none had to be discarded. 

Then we used The WSJ to collect data on FCF, LT debt, ROIC, ROE and RE. Any company that didn’t have Retained Earnings in 2012 was discarded, as was any company that didn’t have an ROIC sufficient to pay ongoing costs of capitalization (at least 8%/yr). Companies where LT debt accounted for more than 50% of total capitalization were also discarded. 

We ended up with 11 companies remaining that were ranked by the market value of their stock. Appropriate multiples ($1-11) were used to arrive at a capitalization-weighted index that has paid 9.3%/yr over the past two market cycles (vs. 2.3%/yr for VFINX).

Bottom Line: Consider having your key DRIPs in the very few large companies that remain able to grow by reinvesting their Retained Earnings, namely, WMT, IBM, XOM and ABT. Add DRIPs for smaller companies when you’re able to do so without going into debt, neglecting your health, avoiding exercise, or skipping vacations.  

Risk Rating: 4.

Full Disclosure: I have DRIPs in WMT, IBM, XOM, and ABT. Automatic monthly additions for XOM and ABT carry no charges; there is a $1.05 charge for WMT and a $1.00 charge for IBM. I invest $280/mo in these 4 DRIPs, for an initial expense ratio of 0.73% ($2.05/$280).

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