Monday, March 28, 2016

The Most Important Thing To Consider When Selecting A Dividend Stock

In selecting a dividend growth stock, investors look at many metrics and try to determine what the future holds for the company. Among those considered are free cash flow, debt levels, current yield, dividend growth rate and fair value. Not to diminish any of these, because they are all very important, but they are not the most important thing that we need to look for.

Free cash flow helps define the viability of the business to generate sufficient cash to meet the operating expenses and replacement capital. A high debt level can be a drain on free cash flow, sometimes to the point the company can no longer afford to pay a dividend.

Current yield defines the money we will earn today. If it is too low we may not be able to cover our living expenses. Inflation is inevitable, especially when the money supply is expanded. A robust dividend growth rate in excess of inflation will ensure we never lose purchasing power.

When selecting a dividend growth stock there is really only one factor that is important – sustainability. As dividend growth investors we are looking for stocks that will continue to raise their dividends into the future.

Below are three things I consider when assessing the sustainability of a dividend growth stock:


Years Of Consecutive Dividend Increases

Inertia is powerful force. Once a company has established a track record of growing its dividend over the decades and developed a shareholder base that expects higher dividends each year, it becomes increasing difficult for management to cut or fail to raise their dividend. No CEO of this type of company wants a dividend cut to occur on his or her watch. There are precious few Dividend Aristocrats remaining and those left enjoy their elite status.


Strong Financial Condition

Dividends are paid with cash, not earnings. Ultimately, investors must focus on the ability of a company to generate cash. In addition to the metrics mentioned above, I also look for:
Declining Shares Outstanding: I am leery of a company that consistently grows its shares outstanding in the absence of major acquisitions.


Growing Equity: If shares outstanding aren’t increasing, and equity is rising then the business is more likely to generate sufficient earnings to cover dividends and share repurchases.

Business Outlook

With the abundance of information available on the internet, the ability to judge past performance is quite simple. One of the most difficult challenges an investor faces is to determine are the future prospects of a company. Certain questions have to be answered. Is the company in a declining industry? Will it be able to reinvent itself in a way that will allow it to sustain growth? What external force could radically change the prospects of the company? These same questions are being asked by the company’s board, and they are equally hard for management to answer even with full access to insider information.

Dividend Stocks With A Sustainable Dividend

Below are several stocks that have increased their dividends for 25 or more years, with a free cash flow payout less than 60%, debt to total capital less than 45%, dividend growth greater than 2% and dividend yield greater than 2.5%:

Aflac Incorporated (AFL) provides supplemental health and life insurance in Japan and the U.S. Products are marketed at work sites and help fill gaps in primary coverage. The company has paid a cash dividend to shareholders every year since 2003 and has increased its dividend payments for 12 consecutive years. Yield: 2.6%

Genuine Parts Co. (GPC) is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products. The company has paid a cash dividend to shareholders every year since 1948 and has increased its dividend payments for 60 consecutive years. Yield: 2.7%

Johnson & Johnson (JNJ) is a leader in the pharmaceutical, medical device and consumer products industries. The company has paid a cash dividend to shareholders every year since 1944 and has increased its dividend payments for 53 consecutive years. Yield: 2.8%

Cincinnati Financial Corp. (CINF) is an insurance holding company that primarily markets property and casualty coverage. It also conducts life insurance and asset management operations. The company has paid a cash dividend to shareholders every year since 1954 and has increased its dividend payments for 56 consecutive years. Yield: 2.9%

T. Rowe Price Group Inc. (TROW) operates one of the largest no-load mutual fund and life cycle fund complexes in the United States, with December 31 AUM of nearly $773 billion. The company has paid a cash dividend to shareholders every year since 1986 and has increased its dividend payments for 28 consecutive years. Yield: 2.9%

Sonoco Products Co. (SON) makes paper and plastic packaging products serves various industries and markets in more than 85 countries. The company has paid a cash dividend to shareholders every year since 1925 and has increased its dividend payments for 32 consecutive years. Yield: 2.9%

Wal-Mart Stores, Inc. (WMT) is the largest retailer in the world, operating a chain of over 10,000 discount department stores, wholesale clubs, supermarkets and supercenters. The company has paid a cash dividend to shareholders every year since 1973 and has increased its dividend payments for 41 consecutive years. Yield: 3.0%

Erie Indemnity Co. (ERIE) is a management services company that provides sales, underwriting, and policy issuance services to the policyholders of Erie Insurance Exchange in the United States. The company has paid a cash dividend to shareholders every year since 1991 and has increased its dividend payments for 25 consecutive years. Yield: 3.1%

Archer-Daniels-Midland Co. (ADM) is one of the world's leading agribusiness concerns, with major market positions in agricultural processing and merchandising. The company has paid a cash dividend to shareholders every year since 1927 and has increased its dividend payments for 41 consecutive years. Yield: 3.2%

Raven Industries Inc. (RAVN) is an industrial manufacturer that provides electronic precision-agriculture products, reinforced plastic sheeting, electronics manufacturing services, specialty aeronautics, and sewn products. The company has paid a cash dividend to shareholders every year since 1972 and has increased its dividend payments for 29 consecutive years. Yield: 3.3%

The ability of a stock to sustain its dividend separates dividend growth stocks from stocks that simply pay a dividend. The latter is quite common, while the former helps define the Best Dividend Stocks in the World.

Full Disclosure: Long AFL, GPC, CINF, JNJ, TROW, ERIE, WMT, ADM, RAVN. See a list of all my Dividend Growth Portfolio Holdings here.

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