Why Dividend Growth Investing Works

Dividend growth investing is not for everyone.  It is a specific style of investing that focuses on finding high quality businesses that have the ability to increase dividend payments year after year.  Dividend growth companies increase investors passive income as the company grows.  Dividend growth investing generally appeals to long term investors who see the benefit of a steadyily rising passive income.

There is a select group of dividend paying companies that have paid increasing dividends for 25 or more years in a row.  These businesses have proven they have a durable competitive advantage that allows them to grow revenue, earnings, and dividends year after year.  Many of these businesses are household names; companies like Wal-Mart, Coca-Cola, Johnson & Johnson and PepsiCo have all paid out increasing dividends well over 25 years in a row.

Do Dividend Aristocrats Outperform?

The Dividend Aristocrat Index is comprised of businesses with 25 or more years of consecutive dividend increases and that meet certain size and liquidity requirements.  The index has historically outperformed the S&P 500 by an average of 2.29 percentage points each year over the last decade.  Surprisingly, the outperformance came with a reduction in risk.  The Dividend Aristocrat Index has a 10 year standard deviation of 13.57% versus 14.69% for the S&P500.  It is rare in the investment world to find a strategy that yields higher returns while simultaneously reducing risk.  Historically, investing in high quality businesses with a  long history of dividend increases has done just that.

Warren Buffett & Dividend Growth Investing

There is no greater advocate for long term investing in high quality businesses that pay dividends than Warren Buffett himself.  Warren Buffett’s portfolio is loaded with high quality businesses with a long history of Dividend increases.  All of his Top 7 positions (by percentage of portfolio) pay rising dividends.  Four of his top 7 positions are Dividend Aristocrats with multi-decade streaks of dividend increases.  These four holdings are:

Warren Buffett backs up his investing style with several informative quotes that elucidate his investing style.  One of his more revealing quotes is:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”

Why is this so?  Wonderful companies compound wealth over time, while fair companies may have short-term gains but lack the deep competitive advantage required to fend off competition and generate above average returns for decades.  Only the best businesses in the world have built such strong competitive advantages.  A short cut to finding these businesses is to analyze their history of dividend growth.  It is not possible for a mediocre business to raise its dividend each year for 25 years in a row as it doesn’t have the ability to grow earnings year after year.  Only a business with a strong competitive advantage can grow revenue, earnings, and dividends year after year.  So what does Warren Buffett say about how long to hold a wonderful company after purchase?

“My favorite holding period is forever”

Warren Buffett argues that wonderful businesses compound your wealth year after year, and therefore should not be sold.  The caveat to this is when/if the company loses its competitive advantage.  Alternatively, if a business is significantly overvalued it might be a good time to sell as well because the market is willing to pay significantly more value than the underlying value of the business.

Analyzing Warren Buffett’s Dividend Aristocrats

Two of Warren Buffett’s four Dividend Aristocrat stocks will be analyzed using the 5 Buy Rules from the 8 Rules of Dividend Investing. The 8 Rules of Dividend Investing use academically verified strategies that have historically improved return or reduced risk to find high quality dividend growth stocks trading at or below fair value.    The two stocks analyzed in this article are Coca-Cola and Wal-Mart.  Both businesses have a long history of profitable growth and have well recognized brands to most US consumers.  Both companies will be analyzed qualitatively, then quantitatively.

Wal-Mart:  Undervalued Industry Leader

Wal-Mart is the world’s largest discount retailer with a market cap of $244 billion.  The company trades at a P/E ratio of under 16, which is significantly lower than its competitors.  For comparison Costco has a P/E ratio of 27, Target has a P/E ratio of 25, and Dollar General has a P/E ratio over 19.  Wal-Mart is significantly cheaper than its peers despite its size advantage due to its recent streak of disappointing comparable store sales results in the US.

Comparable Store Sales Analysis

Wal-Mart posted flat comparable store sales for its most recent quarter in its US based Wal-Mart stores.  These flat comparable store sales were actually the highest the company has seen in 6 quarters.  This is the first quarter in 6 where Wal-Mart US has seen positive comparable store sales data.

Sam’s Club has fared better than Wal-Mart US, but has still seen mediocre comparable store sales growth. The company had flat comparable store sales growth this quarter, following 2 consecutive quarters of declines.

Comparable Store Sales
Quarter Wal-Mart US Sam’s Club
2015 Q2 0.00% 0.00%
2015 Q1 -0.01% -0.50%
2014 Q4 -0.40% -0.10%
2014 Q3 -1.30% 1.10%
2014 Q2 -0.30% 1.70%
2014 Q1 -1.40% 0.20%
2013 Q4 1.00% 2.30%

 

Wal-Mart’s International division is doing much better than its US division.  The company’s comparable store sales for its top 5 international markets are shown below.  Notice the strong comparable store sales growth in its most recent quarter, a reversal from poor comparable store sales in the previous quarter.  Wal-Mart is trending in the right direction internationally with favorable comparable store sales.

 

Comparable Store Sales
Quarter UK Canada Mexico Brazil China
2015 Q2 2.00% 1.90% 0.20% 9.70% -1.60%
2015 Q1 -1.50% -2.60% -1.40% 4.40% -2.50%

Wal-Mart Future Growth

Wal-Mart’s future growth will come from further penetration into emerging markets, new store concepts in the US, and through global e-Commerce growth.  The company grew  international sales by 5.3% year over year on a constant currency basis in its most recent quarter.  Wal-Mart should continue to grow internationally as it uses its strong cash flows to build more stores in faster growing emerging markets.

The bright spot for Wal-Mart US this quarter was its strong comparable store sales growth in its neighborhood market stores, which were up 5.6%.  Neighborhood market stores are about one quarter the size of Wal-Mart super center stores. They focus on grocery items as opposed to the ‘one-stop-shop’ concept of Wal-Mart super centers. Wal-Mart is on track to open between 180 and 200 new neighborhood market stores in the US this year.  Wal-Mart’s success with its neighborhood market concept has shown the company that smaller stores emphasize ‘fill in the gaps’ between its larger super centers.

Following Wal-Mart’s success with smaller stores, it has unveiled a new concept. Wal-Mart’s new express store layout is about one-tenth the size of its super center stores.  The express stores will have gas stations, a drug store, and a dollar store style general merchandise area.  Wal-Mart’s size and scale advantage will give its new express stores lower prices than competing dollar stores. Wal-Mart plans to open about 90 new locations in fiscal 2015. Wal-Mart US CEO Greg Foran said they have seen “continued solid comp sales performance” out of Wal-Mart express stores during the company’s conference call.  The company’s new smaller store concepts will likely drive US growth for the next several years.  The company’s e-Commerce division also offers exciting growth potential.

Wal-Mart grew e-Commerce sales 24% in the second quarter compared to the second quarter of last year. The company gained market share in the competitive U.S. e-Commerce market.  Wal-Mart recently released its Savings Catcher which gives customers the difference of prices on items purchased at Wal-Mart compared to competitor prices if Wal-Mart did not have the lowest price. The savings catcher is another way to tell customers “we have the lowest prices, and we will prove it to you”.

In addition to double digit e-Commerce growth in the US, Wal-Mart also saw double digit e-Commerce growth in Brazil, Mexico, and Chile.  More impressively, Wal-Mart saw triple digit revenue growth in Canada and Argentina. The company is bolstering its e-Commerce division by acquiring talented workers through buying out smaller tech businesses. Recent acquisitions include Adchemy, Stylr, and Luvocracy. Wal-Mart does not expect growth to slow for its e-Commerce division anytime soon.  The company is expecting e-Commerce sales to grow by 25% over full fiscal 2015.

Expected Shareholder Return

Shareholders of Wal-Mart can expect solid returns going forward. The company currently has a dividend yield of over 2.5%, and repurchases about 2.5% of its shares outstanding per year. Shareholders of Wal-Mart can expect a return of about 5% from dividends and share repurchases alone.  The company has managed to grow its total selling square footage by about 3% a year over the last several years. If comparable store sales remain constant, this will add another 3% to shareholder return per year.

Wal-Mart is expected to deliver flat comparable store sales next quarter. As the company continues to expand overseas and implement improvements domestically, its same store sales should rise. If the company achieves comparable store sales increases from 0% to 3% per year, shareholders of Wal-Mart can expect a total return of 8% to 11% from dividends and share repurchases (5%), store count and selling square footage growth (3%), and comparable store sales increases (0% to 3%).

Coca-Cola:  Global Beverage Leader

Coca-Cola is the world’s largest seller of single serve beverages.  The company has a market capitalization of over $182 billion and 17 brands that sell over $1 billion per a year in sales.  Surprisingly, 11 of the company’s 17 $1 billion brands are not sodas; they are non-carbonated drinks like Minute Maid, Powerade, Dasani, Vitamin Water and Simply.  Coca-Cola has done especially well expanding into the juice market.  Amazingly, the company has captured 33% of global juice growth since 2007.

Current Results

Coca-Cola posted favorable 2nd quarter results. Constant currency adjusted revenue increased 3% for the company with worldwide volume growing 3%.  The company’s sparkling (carbonated) volume was up 2% globally, with a 1% volume increase of Coca-Cola in the US.  The volume increase in the US was somewhat unexpected as soda volume has been declining in the US and other developed markets in recent years as consumer preferences change away from sodas.

Coca-Cola grew sparkling (carbonated) beverage volume 2% globally by heavily advertising through its sponsorship of the FIFA world cup. Sprite posted the strongest volume gains, with a 6% increase.  Fanta volume grew 2%, and Coca-Cola volume was up 1% globally. Coca-Cola operations are split geographically.

Coca-Cola is doing very well in the Asia/Pacific region. Sparkling volume increased 10% in China for the quarter on strength from the Share a Coke campaign.  China is perhaps the company’s most important emerging market; double digit growth in the country is a success for Coca-Cola.   Asia Pacific volume grew 8% for the quarter overall. Coca-Cola increased sparkling volume 9% in the region, and still volume 7%. The company’s ability to grow its flagship sparkling brands in China point to a long growth runway in the region for Coca-Cola.

The company’s other bright spot is the developing markets of Eurasia and Africa. Coca-Cola grew volume 5% in this region for its most recent quarter. Gains came from deeper market penetration brought on by the FIFA world cup advertising campaign. Sparkling beverages grew a modest 3%, while still beverages were up 12% in the quarter.  Coca-Cola’s impressive still (non-carbonated) beverage growth in the Eurasia/Africa region shows the company continues to compete successfully in the non-carbonated beverage industry.

Coca-Cola’s European segment posted mixed results for the 2nd quarter. Northwestern Europe, Germany, and the Iberian Peninsula (Spain, Portugal) posted small volume growth. Central and Southern Europe volume declined 4% for the quarter. As a whole, Coca-Cola’s European segment posted no volume growth for the second quarter.  Weak European results are juxtaposed against the company’s strong emerging market growth.  Coca-Cola is having a difficult time growing sales in the stagnant developed European economy.

Like Europe, Latin America’s volume was flat for the quarter. The company’s South American business units performed well, growing volume 8%. Volume in Brazil did not grow due to strong competition. Volume in Mexico declined 3% due to the company’s institution of an excise tax. Despite these setbacks, still (non-carbonated) volume increased 3% for Latin America, while sparkling beverage volume declined 1%.  Volume growth will likely rebound as the effects of the excise tax will not impact long-term growth.

Coca-Cola gained market share in the sparkling category for the 2nd quarter of 2014 in North America. Despite gaining market share, sparkling volume was flat. Still beverage volume increased 1%. Coca-Cola’s still portfolio has either held or grown market share for 17 consecutive quarters. Not only does Coca-Cola North American have dominant sparkling brands, they have dominant still brands as well.  The future for Coca-Cola’s North American growth lies in its ability to expand its current still brands and acquire new brands.

Coca-Cola’s Stake in Monster

Coca-Cola recently announced  it will acquire a 16.7% stake in Monster, the fast growing energy beverage business for $2.15 billion, or about $77 per share of Monster. The deal is expected to close at the end of 2014 or the beginning of 2015. Coca-Cola will finance the transaction with excess cash.

The transaction is not a simple equity purchase; the companies are transferring brands to better align each company with its area of expertise. Coca-Cola will transfer its worldwide energy brands which include NOS, Full Throttle, Burn, Mother, Power Play, and Relentless to Monster. In return, Monster will transfer Coca-Cola ownership of Hansen’s Natural Sodas, Peace Tea, Hubert’s Lemonade, and Hansen’s Juice Products. The deal will also make Coca-Cola Monster’s preferred distribution partner worldwide, while Monster will become the exclusive energy play of Coca-Cola.

The trading of brands better aligns each business with what it does best. Monster sold $3.1 billion in energy drinks in 2013 in the US, versus $3.4 billion for Red Bull. Monster’s energy drink sales are rapidly rising in the US and will likely be the number one energy brand in the US when the acquisition closes at the end of 2014 or the beginning of 2015.

Adding NOS and Full Throttle sales to Monster’s sales will create an energy business that would have had $3.5 billion in energy drink sales in the US for 2013; larger than Red Bull. Monster is adept at marketing energy drinks in the US. The company will likely be able to position the NOS and Full Throttle brands for faster growth domestically than Coca-Cola has been able to achieve.

Coca-Cola will benefit from Monster’s non-energy drink brands. The Peace Tea brand was the 10th largest ready to drink tea brand in the US by 2013 revenue. Coca-Cola is not a dominant player in the ready to drink tea industry despite owning the Gold Peak , FUZE, and Honest Tea brands. Ready to drink tea has grown over 6% per year over the last 6 years. The market is expected to continue to grow significantly faster than the overall beverage industry over the next several years as consumers continue to switch from sodas to healthier alternatives.  Coca-Cola’s acquisition of Peace Tea will strengthen its competitive position against the larger brands like Arizona, Lipton, and Snapple.

Internationally, Monster trails Red Bull significantly. About two thirds of Red Bull’s sales are international, versus just 23% of sales being from international markets for Monster.  Monster should benefit greatly from access to Coca-Cola’s extensive global distribution network. Coca-Cola is the leading seller of carbonated beverages worldwide; the company’s distribution network is second to none.

Coca-Cola is significantly larger than Monster. Monster has a market cap of about $12 billion versus $182 billion for Coca-Cola. Monster is still in its growth phase, as energy drink demand increases year after year. Coca-Cola is a more mature business that is focusing on global expansion funded from its strong cash flows and iconic brands.

Coca-Cola’s stake in Monster will allow the company to participate in Monster’s growth going forward. If Monster can continue to grow its revenue and earnings between 8% and 10% a year, shareholders of Coca-Cola will see additional growth of about 0.1% a year from their share of the company’s growth. This may seem inconsequential now, but Coca-Cola’s stake in Monster will account for a larger share of its overall growth as Monster grows faster than Coca-Cola in the future.  The deal also opens the door for Coca-Cola to acquire a larger stake of Monster later on and aligns both businesses’ futures.

Shareholder Return

Shareholders of Coca-Cola have much to be happy about. The company has a dividend yield near 3%, regularly repurchases shares, and has a long history of growth.   Coca-Cola announced it expects to buy back between $2.5 billion and $3 billion worth of shares for the full year of 2014. This amounts to around 1.5% of the company’s market cap at current prices. Coca Cola has already completed about $1.5 billion worth of net share repurchases this year, and has another $1 billion to $1.5 billion expected for the next two quarters.

Coca-Cola has managed to grow revenue per share and dividends per share by about 9% a year over the last decade, despite headwinds from the slowly declining soda industry.  Shareholders of Coca-Cola can expect double digit returns going forward from dividends, share repurchases, and organic growth.

Quantitative Analysis

This section analyzes Coca-Cola and Wal-Mart using the 5 Buy Rules from the 8 Rules of Dividend Investing.  Both Wal-Mart and Coca-Cola are compared to each as well as 130 additional stocks with 25 or more years of dividend payments without a reduction.  Each rule contains historical evidence on how it can benefit your investing experience.

Rule 1:  Dividend History

  • Coca-Cola has increased its dividend payments for 52 consecutive years
  • Wal-Mart has increased its dividend payments for 41 consecutive years. Both businesses have raised their dividends for over 4 decades.  Coca-Cola has one of the longest active streaks with an amazing 52 consecutive years of dividend increases without a reduction.Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 2.29 percentage points per year.
    Source:  S&P 500 Dividend Aristocrats Factsheet

Rule 2:  Dividend Yield

  • Coca-Cola has a dividend yield of 2.9%, the 42ndhighest out of 132 stocks with 25+ years of dividend payments without a reduction.
  • Wal-Mart has a dividend yield of 2.5%, the 66thhighest out of 132 stocks with 25+ years of dividend payments without a reduction.Both businesses have dividend yields above the market average.  Coca-Cola is currently yielding near 3%, which may appeal to income oriented investors.Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 1.76 percentage points per year from 1928 to 2013.
    Source:  Dividends: A Review of Historical Returns

Rule 3:  Payout Ratio

  • Coca-Cola has a payout ratio of 60%, the 96thlowest out of 132 stocks with 25+ years of dividend payments without a reduction.
  • Wal-Mart has a payout ratio of 39%, the 44thlowest out of 132 stocks with 25+ years of dividend payments without a reduction.The lower a company’s payout ratio, the more it can raise its dividend payments above overall company growth.  Wal-Mart has a fairly low payout ratio, while Coca-Cola has less room for dividend increases over company growth due to its higher payout ratio.Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
    Source:  High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Rule 4:  Long-Term Growth Rate

  • Coca-Cola has a long-term growth rate of 9%, the 11thhighest out of 132 stocks with 25+ years of dividend payments without a reduction.
  • Wal-Mart has a long-term growth rate of of 8.2%, the 20thhighest out of 132 stocks with 25+ years of dividend payments without a reduction.Long-term growth rate is calculated as the lesser of 10 year revenue per share growth and 10 year dividend per share growth.  Both businesses have had strong growth over the last 10 years.Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4 percentage points per year from 1972 to 2013.
    Source:  Rising Dividends Fund, Oppenheimer, page 4

Rule 5:  Long-Term Volatility

  • Coca-Cola has a long-term standard deviation of 18.7%, the 9thlowest out of 132 stocks with 25+ years of dividend payments without a reduction.
  • Wal-Mart has a long-term standard deviation of 19.1%, the 10thlowest out of 132 stocks with 25+ years of dividend payments without a reduction.Long-term volatility is calculated as the 10 year daily price standard deviation of each stock.  Stocks with lower standard deviations tend to rise and fall less than stocks with higher standard deviations.Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
    Source:  Low & Slow Could Win the Race

Final Thoughts

Both Wal-Mart and Coca-Cola are Top 10 stocks based on the 8 Rules of Dividend Investing.  Wal-Mart is especially attractive right now as recent poor results have depressed the company’s P/E ratio.  If Wal-Mart reports favorable US comparable store sales in the future, the company’s stock will likely rise.  Coca-Cola is not undervalued at this time, and is likely a “high quality business trading at a fair price”.

Dividend growth investing is not for everyone.  It requires the patience to hold your stock in businesses through the ups and downs of the market. Also, reading and reviewing stock analysis data is important in order to ensure the success of your investment.  The strength of dividend growth investing is that it puts investor focus on growing dividend payments rather than fluctuating stock prices.  Only the highest quality businesses can raise dividends year after year.  By focusing on high quality dividend growth stocks with a long history of rewarding shareholders, individual investors can build a portfolio that should pay rising dividend income year after year. This can surely help you reach for financial goals faster.

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