Dividends are wonderful. Buy stock in a strong dividend payer, and you’ve now got a reliable stream of passive income coming your way each quarter.
Many great personal finance sites are devoted to buying their financial freedom through a strong stream of dividend income. Many bloggers even choose to list out their current holdings, and you see many of the same names appear again and again in their portfolio. Coca-Cola (KO), Walmart (WMT), Johnson & Johnson (JNJ), Wells Fargo (WFC), 3M (MMM), McDonalds (MCD). All of these companies are blue chip, have strong cash flows, and have dividend yields around 3% or more.
Many of these names appear on the “dividend aristocrat” list again and again, and for good reason. They have a strong history of paying (and increasing!) their dividends over time.
While I’d never discourage anyone from putting these names in their portfolio, I prefer a slightly different strategy. As much as I love dividend income, I’m not particularly that interested in investing in any of the names listed above. Why? Well, while many of the companies listed above have strong yields, they all come with similar long term drawbacks that may not provide me with the kind of total return I’m after, and I’m far more interested in total return than I am in simply a strong dividend yield.
All of those companies have the following negatives which gives me pause from buying their stocks:
1) Slow revenue growth – Over the long term, revenue growth is required to drive stock price appreciation. Most of those massive companies are still growing, but very slowly. MCD has grown its top line around 5%. JNJ 3%. WMT at 4%. Massive size makes it increasingly more difficult to put up good revenue growth, and each of those companies are simply massive. Size can be a hindrance to future returns. Call it ‘too big to succeed’.
2) Growth by acquisition – Because their core markets are mature, many of these companies are now looking to acquire their way to growth. Doing so makes sense, but comes with real risks. Acquiring another company is a huge challenge, as there are usually accompanied by layoff’s, culture clash, and integration complexity. In fact, most acquisitions fail to pay off for the acquiring company. Hence, I’d rather focus my investment dollar on companies that grow organically rather than by acquisition. One way to do that is with Motley Fool investing.
3) Increasingly complicated – JNJ owns hundreds of companies, and has thousands of product lines. The same goes for 3M and GE. The bigger they get, the more complex they are, which can make them harder and harder to manage. Can a great management team get it done? Sure! But why make it harder than it needs to be?
4) Egregious pay packages – Big companies pay big salaries, and they attract managements teams that are working for big payouts, not because they want to grow the organization. Just look at Coke’s recent management compensation plan to see what I’m talking about.
5) Negative consumer trends – Consumer trends may be shifting away from these more established companies that dominated the 20th century. Consumers are eating healthier, which is causing soda (Coke) and fast food (MCD) sales to stall. Consumer want to shop and bank online, which may be a long-term headwinds for Walmart and Wells Fargo. Over the long term, those that thrive may have to alter their business model’s, which can be extremely difficult for a large organization to do.
6) Higher short term taxes – Lastly, if you are retired, you want a strong dividend yield to support your lifestyle. But what if you are still years away from retirement? Getting your returns as cash increase your current year tax bill. Sure, its not by much in the beginning, as dividend taxes are quite low, but its still something to consider.
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So, as a dividend lover, what’s my solution to the above problems? I’m on the lookout for the companies that will be the dividend achievers of the 21st century. I want companies with good top line growth, run by strong management teams (often founders!), with consumer trends in their favor. As you can imagine, finding these companies is difficult, and no company will ever perfectly match what I’m looking for, but I think there are a few hiding in plain site that you wouldn’t normally consider for the dividend portion of your income.
1) Whole Foods – WFM – With a dividend yield around 1.2%, this wouldn’t hit your average dividend seekers radar. However, there is so much to like about whole foods. They play nicely into the ‘better health’ trend, as same store sales are growing at a good clip. They only have 400 stores or so, and have a goal of 1,200 in the US alone. Add in the international opportunity and that gives us the possibility of decades of 10-15% top line growth. And with co-founders Walter Robb and John Mackey running the show, you know your capital will be in good hands. Mix in a small, but fast growing dividend, and WFM could be a dividend monster in the decades ahead. Look for dividend increases above 10% per year with this name.
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2) Starbucks – SBUX – Another small yield of 1.3% won’t get you big payouts in the near term, but the long term looks very, very bright. Fantastic same-store-sales numbers, lots of room for store growth (believe it or not), and the move to add La Boulange food items to their cafe’s should bring decades of strong top line growth. With founder Howard Schultz running the show, our capital is in a capable manager’s hands with a strong history of good decision making. They are also moving into the tea market (with Teavana) and invading your local grocery store with their consumer packaging division. They are also on the forefront of digital payments (who knew?) and are adding stores in the suburbs with drive-thru lanes that are increasing visits at a very high rate. With plenty of strong revenue growth ahead, the dividend is primed to grow quickly. Top line growth, bottom line growth, and a fast growing dividend. What’s not to like?
3) Mastercard – MA – What portion of transactions around the world are done with cash or check each year? Would it surprise you to hear that number shakes out at roughly 85%? I certainly was! How is that for a massive opportunity! While a yield of 0.70% shouldn’t get you all that excited, until you realize that Mastercard is growing its dividend by about 50% a year for the last 5 years! Mix in a dominate market position, strong management team, and margins that will continue to rise, and Mastercard could one day be a dividend seekers dream.
So, that’s my plan. Whole Foods, not Walmart. Starbucks, not McDonalds. Mastercard, not Wells Fargo. Yes, I will have to wait a bit until I’m rolling in the dividend checks, but that’s OK. I’m in each of these companies for the long term.
5 years out, I’d be willing to bet the my future self will thank me that I invested this way. My capital appreciation should be higher, my short term tax bill will be lower, and the companies above will be stronger than ever.