In my previous article found here I reported on Dividend Champions that I felt were fairly valued. In contrast to Dividend Champions that have raised their dividends every year for 25 consecutive years, Dividend Contenders have raised their dividends every year for 10 to 24 years. Therefore, I feel that the Dividend Contenders list also provides numerous excellent candidates for a retirement portfolio interested in generating a constantly-increasing income stream. Moreover, I believe there are many candidates on the Contenders’ list that also meet the seven criteria of quality and quantity that the venerable Ben Graham expressed. The seven criteria are repeated here as follows:
- Adequate Size of the Enterprise
- A Sufficiently Strong Financial Condition
- Earnings Stability
- Dividend Record
- Earnings Growth
- Moderate Price / Earnings Ratio
- Moderate Ratio of Price to Assets
General Considerations and Thesis
In order to avoid being repetitive, I suggest that the reader refer back to my previous article through the link provided above, in order to review the principles, justifications and primary thesis underpinning both these articles. However, the following summary of the main points that I am articulating will hopefully prove useful.
First and foremost, I believe that retirees can, and should, design and build a portfolio that contains the opportunity of providing an increasing income stream. Perhaps even more importantly, if this process is started early enough, a portfolio can be built that is self-sustaining regarding the distribution of income. In other words, the portfolio can throw off enough cash to meet the retiree’s income needs without having to harvest principle. Second, I believe high-quality blue-chip dividend growth stocks can provide a safe and effective vehicle towards achieving those goals. Moreover, I further believe in controlling risk through diversification and the prudent adherence to fair valuation are imperatives.
Finally, I favor fixed income when yields are high enough to generate an adequate level of current income. But unfortunately, I do not feel that that situation currently exists. Therefore, I am comfortable suggesting that the risk profile of fixed income is currently aberrantly high, and therefore, temporarily suggest avoiding investing in new ones, in favor of the higher-yielding blue-chip dividend paying stalwarts. In the future, when the levels of interest rates change in favor of higher yield, the portfolio could be rebalanced if the retiree prefers.
However, I want to emphasize that I consider the current fixed income situation as both extraordinary and temporary. Consequently, when the time comes when interest rates do normalize, I would once again support their inclusion in a well-diversified retirement portfolio. Because, for this to be true, the current yields on fixed income would be significantly higher than equities, which is normal, but not the case today. Therefore, the retiree could get more current yield with fixed income, while utilizing an appropriate blend of equities as the driver of growth and as an income inflation hedge.
Fairly Valued Dividend Contenders
Ben Graham’s criteria 6 (Moderate Price / Earnings Ratio) and 7 (Moderate Ratio of Price to Assets) primarily relate to valuation. As I expressed in my first article and again here, I believe that valuation is a critically important component of a good common stock investment. No matter how much I like a company, I am never willing to pay more than I believe the stock is worth. As it did in the first article, I would like to share words of wisdom from Ben Graham’s most famous pupil Warren Buffett on the subject of valuation:
“Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”
The Dividend Contenders list currently has 183 names on it. To narrow the list down, I have hand screened the Dividend Contenders one company at a time, as I previously did with the Dividend Champions, looking for those candidates that I believed best exemplified Ben Graham’s criteria, which simultaneously could be bought at fair value or below. It should be noted that my selection process with the Contenders’ list was also somewhat arbitrary where I excluded companies which did not possess the consistent records of earnings that I personally prefer.
Through this process I have identified 88 of the 183 Dividend Challengers that I felt meet Ben Graham’s criteria and are simultaneously trading at fair value or below. Although I believe that many of these Dividend Contenders might be worthy candidates, this list is offered as a precursor to a more comprehensive due diligence process. Also, because the market prices stocks so dynamically, valuations could moderately change between the time that this article was authored and current time.
I believe there are many good investments on this list of 88. However, some are more growth oriented, while others are more income oriented. Therefore, their relative attraction will be a function of the individual investor’s own goals, objectives and risk tolerances. In other words, although I think many of these candidates possess attractive total return potential, as it was with the Dividend Champions, some will be more appealing for their yield, others for growth and yet others for a combination of both.
At this point, I believe it is useful to interject the principle that future returns comprising both capital appreciation and dividend income will be a function of each company’s earnings growth rate, and the valuation you pay on purchase. But as I have previously alluded to, some Dividend Contenders grow fast and some do not. Consequently, and as a general rule, assuming that each is bought at a correct valuation, faster earnings growth should produce the highest long-term returns, but do so at the highest relative risk levels. Higher growth is harder to achieve, and therefore more risky. Moreover, higher yield may produce greater total income, but perhaps a lower total return. Therefore, each situation should be examined based on its own characteristics and merits, in concert with your own portfolio goals and objectives.
For additional clarity, I will feature a sample company from each of the cap size subsets. However, since the Dividend Contenders by definition are comprised of companies that have raised their dividends for 10 to 24 consecutive years, some of my sample companies may not meet Ben Graham’s criteria of 20 years of dividends.
This will allow me to utilize FAST Graphs™ comprised of 15 years or less. Those of you who read the previous article may recall that I was using 20-year earnings and price correlated graphs. However, the problem is that we only type in every other year due to space constraints on graphs with longer than 15 years of history. With the shorter graphs, each year is not only plotted but all the data is also typed in. Consequently, each year’s earnings growth and dividends will be clearly revealed in detail.
Furthermore, as I did in the previous article, I have placed a red circle around the general area of the great recession in order to illustrate how the fear of capital loss due to sinking stock prices is mostly a paper tiger. Also note how little of a long-term impact the great recession, which traumatized so many investors, really had on these strong companies and their longer-term performance. Dividends continued to grow and both stock prices and earnings drops (if any) quickly recovered.
Once again, I remind the reader that all Dividend Contenders are not the same. Some grow faster, some yield more, some are riskier than the others. etc. However, it should also be acknowledged that many Dividend Contenders are in the early stages of developing their dividend legacies, which could also imply more growth and perhaps higher risk than is found with most Dividend Champions.
The Two Primary Stages Of A Retirement Portfolio
Before we begin looking at the specific Contenders, I feel that a few words should be written about what I consider to be the two primary stages of a retirement portfolio - the accumulation phase and the income or distribution phase. The accumulation phase refers to the time prior to when you are actually going to be harvesting income from the portfolio. Obviously, the income distribution phase refers to the time when you are actually taking distributions to live off of, or to supplement your living once you are retired.
Depending on each individual investor’s tolerance for risk, as well as such factors as the amount of assets they have or are capable of accumulating and the amount of time they have before retirement, will have a great impact on the type of investments they might choose. However, as a general rule, I will assume that total return investments are more appropriate for the accumulation phase, and slower growing but higher current yielding income investments are more appropriate for the income phase.
But most importantly, a list as large as the Dividend Contenders will be comprised of companies that are most appropriate for either phase of a retirement portfolio. Stated more simply, although all Dividend Contenders share the criteria of the streak of dividend increases of 10 to 24 years, their rates of change of earnings growth, etcetera, are not consistent. Therefore, as I’ve stated before, not all Dividend Contenders are the same. In addition to what I pointed out in the article on Dividend Champions you will find myriad differences between one Contender to the next. Therefore, as I review the specific examples, I will emphasize which phase of the retirement portfolio they are most appropriate for.
The Large-Cap High Growth Subset for the Accumulation Phase
The first three examples are large-cap above-average dividend growth stocks. The first example is an MLP that could technically fit nicely into either the accumulation phase or the income phase. However, I highlight it under the accumulation phase because of the high total return that it has generated for its stakeholders. Nevertheless, I believe that this company could also selectively be utilized in the income phase.
The next two examples, Qualcomm (QCOM) and CVS Caremark (CVS) are traditional C Corporations with moderate yields and above-average growth potential. Therefore, I suggest that the prospective investor look more towards the future potential yield than on the moderate current yield. More directly stated, these are accumulation phase suggestions that could produce a greater total return and a substantially higher future growth yield (yield on cost).
Kinder Morgan (KMP)
Since our first sample, Kinder Morgan Company, is a master limited partnership we will graph it utilizing our Funds From Operations (FFO) function in lieu of earnings-per-share. The Funds From Operations function is primarily utilized to look at REITs and MLPs. When this function is utilized, the reviewer is actually offered three distinct valuation measurements. The first is the Funds From Operations orange justified valuation line. However, regarding Kinder Morgan specifically, although there is a correlation between price and the orange valuation line, it is not a perfect match. (Note also that unrelated business income tax may present an issue when investing in MLPs in IRAs).
Therefore, FAST Graphs™ calculates a normal P/FFO (dark blue line) that reveals how Mr. Market has traditionally valued the shares based on Funds From Operations. In this example, the market has normally valued Kinder Morgan at 9.7 times Funds From Operations (FFO). Therefore, utilizing this valuation metric implies that the company is fairly valued when the black price line is touching the blue line, overvalued when it is above it and undervalued when it is below it. Consequently, on this basis Kinder Morgan with a Price/Funds From Operations of 8.5 appears to be currently undervalued.
The third valuation metric is what we call the income valuation line for REITs and MLPs (note this line is only useful for REITs and MLPs). Once again, the same concept applies, when the black price line is touching the pink line it implies fair value based on the income distribution, and when above the pink line overvaluation is implied, and when below the pink line undervaluation is indicated. Kinder Morgan appears fairly valued on this basis. Finally, the important point is to notice how closely the stock price follows all the valuation metrics.
Funds From Operations (FFO) is a very close cousin to operating cash flows, and the source of distributable cash for MLPs. But most importantly, notice how Kinder Morgan has substantially outperformed the general market as measured by the S&P 500 on both a capital gain and income basis.
Qualcomm Inc. (QCOM)
For those unfamiliar with this company, the following brief description courtesy of Reuters should be useful:
“QUALCOMM Incorporated (Qualcomm), incorporated in 1985, designs, manufactures and markets digital wireless telecommunications products and services based on its code division multiple access (CDMA) technology and other technologies. The Company operates through four segments: Qualcomm CDMA Technologies (QCT); Qualcomm Technology Licensing (QTL); Qualcomm Wireless & Internet (QWI), and Qualcomm Strategic Initiatives (QSI). QCT is a developer and supplier of CDMA-based integrated circuits and system software for wireless voice and data communications, multimedia functions and global positioning system products.”
Qualcomm paid its first dividend in 2003 which has grown rapidly along with the company’s earnings. Consequently, we offer this as a potential candidate for retirees in the accumulation phase desirous of above-average total return and the potential for a growing dividend yield. The idea would be that future dividend income might be high enough to meet the income needs once the retiree enters the income distribution phase. Although Qualcomm may not continue growing at its historical rate, consensus expects the company to continue growing earnings at 15% to 20% over the intermediate to long-term future.
Qualcomm’s track record clearly illustrates the power of investing in the fast-growing but moderate yielding Dividend Challenger. Therefore, I suggest that investors in the accumulation phase might want to consider Qualcomm with its moderate but potentially fast-growing dividend.
The large-cap Moderate Growth (10%-15%) Subset and The large-cap Average Growth (10% or less) Subset With Candidates for Both the Accumulation and Income Distribution Phases
These next two subsets will contain companies that could be effectively utilized for retirees in either the accumulation or the income distribution phases of their portfolio construction. Part of my reasoning for lumping these two subsets together is to illustrate how different the specific components of the Dividend Challengers’ list can be. David Fish provides a great service in my opinion by preparing and maintaining his CCC lists of Champions, Contenders and Challengers found here.
However, it needs to be understood that these lists are created based on the specific criteria of their dividend growth streaks. Therefore, it should not be assumed that every member of every list is a good investment. These lists provide a great service, but they require a commitment by the individual investor to conduct their own due diligence on any specific candidate. Current valuation, and/or the future prospects of each company should be carefully scrutinized.
CVS Caremark (CVS)
CVS Caremark offers a moderate current yield and an above-average past and future expected growth rate. Therefore, I would consider this candidate most appropriate for the accumulation phase of a retiree’s portfolio.
As a reminder, notice how quickly both price and earnings have recovered from the great recession (the area in the red circle). I have put a red circle on all the graphs to illustrate that the fears from the great recession are overblown.
Thanks to an above-average earnings growth rate, CVS Caremark was still able to outperform the S&P 500 since 1999 on a total return basis, even though the company’s shares were overvalued in 1999. I would also like to focus the reader’s attention on this company’s low payout ratio and its high dividend growth rate. Therefore, even though the current yield is moderately low at 1.7%, the future growth potential should be a consideration for investors in the accumulation phase of their retirement portfolios’ construction.
Wisconsin Energy Corp. (WEC)
Wisconsin Energy Corp. is one of the fastest-growing utility stocks in the country. Moreover, this Dividend Challenger offers an above-average 3.5% current yield. However, even though the company appears reasonably valued, prospective investors might want to wait for a slight pullback before investing. Once again, notice how little of a long-term impact the great recession had on this company’s share price and earnings longer-term.
Wisconsin Energy has generated strong performance since 1999 on both a capital appreciation and dividend income basis. However, the prospective investor might want to reconcile themselves with the dividend cuts and weakness during the recessionary period of 2001. On the other hand, consideration should also be given to the fact that the dividend growth was very strong during the great recession of 2008 and beyond. Therefore, Wisconsin Energy may have learned from past mistakes.
Faster Growing Mid-Cap Subset
In theory, mid-cap companies might be expected to offer faster growth than their larger counterparts simply because they have more room to grow. However, that is not always the case, but prospective investors may be wise to keep this notion in the back of their mind as they review mid-cap candidates.
Factset Research Systems Inc. (FDS)
Factset Research Systems Inc. (FDS) is a mid-cap growth stock with a moderate yield but very fast earnings and dividend growth. Once again, we see that the great recession had only a temporary, but very mild impact on this company’s business, its stock price and its dividend.
For those not familiar with the company, the following description is taken directly from their website:
“FactSet, a leading provider of financial information and analytics, helps the world’s best investment professionals outperform. More than 48,000 users stay ahead of global market trends, access extensive company and industry intelligence, and monitor performance with FactSet’s desktop analytics, mobile applications, and comprehensive data feeds.”
Due to its strong earnings growth rate, Factset Research Systems has produced a very strong track record on behalf of the shareholders. Although its current yield is only moderate, the following performance table shows that the company’s dividend growth rate has been exceptional and above average.
Moderate Growing Mid-cap Subset
As I alluded to earlier, mid-caps, in theory, provide the opportunity for above-average growth. However, not all mid-caps grow at above-average rates. On the other hand, there are average growing mid-caps that provide enough current yield in conjunction with the opportunity for moderate growth to be attractive considerations for the investor in the dividend distribution phase.
Cullen/Frost Bankers Inc (CFR)
Cullen/Frost Bankers Inc is offered as an example of a moderately-growing mid-cap company with an above-market current dividend yield. The following description taken directly from their website is offered for those not familiar with this company:“Frost is the banking, investments and insurance subsidiary of Cullen/Frost Bankers, Inc. (NYSE:CFR), a financial holding company with $20.9 billion in assets at June 30, 2012. One of 24 U.S.banks included in the KBW Bank Index, Frost provides a full range of business and consumer banking products, investment and brokerage services, insurance products and investment banking services. Frost operates more than 115 financial centers across Texas in the Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio regions.”
The primary reason I utilize this company as a sample is to illustrate how different one Dividend Contender can be from the next. My previous examples were lower-yielding higher-growth examples offered for the accumulation phase. This company appears to be a worthy candidate for the income distribution phase.
Cullen/Frost Bankers Inc. has produced a solid track record and an above-average dividend growth rate since 1999. Consequently, it appears to be an appropriate investment for the retiree in the income distribution phase.
For the sake of brevity, which this article has already forsaken, I will let the reader review the list of small-cap Contenders and the two specific examples without offering any rhetoric or explanation. Frankly, I’m not sure small-caps belong in a retirement portfolio unless the investor has a high tolerance for risk coupled with adequate diversification. Nevertheless, I believe the following examples illustrate how different the specific companies within a broad list such as the Dividend Contender can be. In other words, I feel it’s important to look beyond the obvious and deeper into each company on the list before investing.
I hope that I have been able to illustrate the diversity among the 183 companies on the Dividend Contenders list. Although there are many Dividend Contenders that are worthy of holding a place in the retiree’s portfolio, there also many that are not quite there yet. On the other hand, even for those that are not quite ready for prime time, I feel they are worthy of holding a place on the future potentials’ list.
But perhaps most importantly, for those companies that are worthy of holding a place in the retirees’ retirement portfolio, I believe many of them are attractively valued today. Consequently, the Dividend Contenders list represents a fertile field of attractive investments for those seeking income and for those seeking growth (total return) and of course, for those interested in both. But as always, due diligence beyond what has been presented here is highly recommended.
Disclosure: Long QCOM at the time of writing.Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
This article was written by Chuck Carnevale. If you enjoyed this article, you can read more of his articles here.