After many dark months, investors' appetite for risk is back, prompting a buying binge that is driving up the value of some pretty speculative stocks and asset classes. You can play the momentum game, hoping to enter and exit a hot stock at just the right juncture. Or you can ignore the siren song of quick but highly uncertain gains and instead invest for the long term, using the tried-and-true technique of identifying companies that regularly raise their dividends.
History is on the side of the dividend strategy. Howard Silverblatt, of Standard & Poor's, calculates that from 1926 through March 2009, reinvested dividends accounted for 44% of the 9.5% annualized return of the S&P 500-stock index. From 1972 through April 2009, dividend growers returned 8.7% annualized, according to Ned Davis Research, compared with 6.2% for the S&P 500 and just 0.7% for stocks that paid no dividends.
Why has a dividend-growth strategy stood the test of time? First, to commit to boosting its payout, a company must be financially strong and confident that its business plan will generate a stream of profit and cash flow. A growing payout, says Judy Saryan, manager of Eaton Vance Dividend Builder fund, is the "best, most tangible signal that a company's board of directors and management have confidence in future cash flows."
Saryan notes some subtle effects of managers' commitment to boost the distribution annually. Shareholders' anticipation of that dividend check forces a company's leaders to be more disciplined with their cash and more careful in selecting capital projects. Paying dividends discourages dubious accounting: The company must have the real money to make the payments.
The real thing
The trick is to identify companies that have the stamina to keep increasing dividends for many years -- and to acquire their stocks when they are selling at reasonable prices. A sustainable business model is crucial. You want a company with a strong balance sheet, robust free cash flow (the money left over after capital expenditures needed to maintain the business) and a high return on equity, which enables the business to both pay out a handsome dividend and retain enough earnings to reinvest in its growth.
One way to analyze the expected return on a dividend-growth stock is to compare it with a U.S. Treasury bond. Let's take the example of Coca-Cola (symbol KO). Over the next four quarters, Coke should pay a dividend of close to $1.70 a share; based on its recent share price, that's a yield of 3.4%, slightly less than the 3.9% yield of a ten-year Treasury.
But compare the potential of the two investments over the next ten years. Let's say that both Coke's earnings and its dividend grow by 8% per year. Over the next decade, that 3.4% yield will swell to 7.3% based on today's share price (and, for the truly patient investor, to 15.9% after 20 years), while the fixed-income Treasury will still return a bit less than 4% for someone who buys the bond today. Moreover, assuming the price-earnings ratio remains the same, you'll earn an annualized total return of 11.4% (3.4% annual yield plus 8% annual capital appreciation), compared with roughly 4% for the Treasury. If the P/E rises, you will earn more than 11.4%; if it declines, your return will be less.
Coke, which has raised its dividend for 47 consecutive years, certainly passes the endurance test. Its iconic brands, unparalleled global distribution network and steady growth in beverage volumes generate high returns on capital and copious free cash. Goldman Sachs's Judy Hong calculates that Coke's cost of capital is less than 8%, compared with its return on invested capital of 18%. No wonder Warren Buffett's Berkshire Hathaway is Coke's largest shareholder.
Ugly wares, nice numbers
We know many of you are averse to investing in tobacco companies. But if you're not, you'll appreciate the striking financials of Philip Morris International (PM), the world's largest publicly traded tobacco firm. Based in New York City, Philip Morris books 100% of its sales outside the U.S. The maker of Marlboro generates an eye-popping 60% return on equity, partly because its stable, predictable cash flows allow it to carry more leverage on its balance sheet. Capital-investment needs are nominal, which helps it produce $7 billion of free cash flow a year. At the current dividend rate of $2.16 per share, the stock yields a sturdy 4.9%.
Philip Morris's outlook is bright. Consumption of cigarettes is shrinking in Western Europe and Japan but growing briskly in emerging markets, where Philip Morris earns the bulk of its profits. Overall, the number of cigarettes sold is growing just 1% to 2% a year, but the company has an unusual ability to raise prices -- one of the things about selling an addictive product. Philip Morris thinks it can boost earnings per share 10% to 12% a year over the long term and has committed to paying out at least 65% of its earnings in dividends. Big, ugly tobacco companies like this one tend to treat loyal shareholders well.
Dominant food supplier
Let's move to a predominantly domestic company, Sysco Corp. (SYY). The leader in its field, Sysco distributes food to hospitals, hotels, campuses, restaurants and company cafeterias across the U.S. It has a peerless distribution system, with the most warehouses and delivery trucks through which to push growing volumes of food and related supplies (annual revenues are $37 billion).
Earnings may be flat this year because Americans aren't eating out as much. But as Cliff Remily, associate manager of Thornburg Investment Income Builder fund, says, Sysco's history suggests that it will emerge stronger after the recession because it's a serial consolidator (more than 100 acquisitions in 40 years) and by far the largest and strongest player in a fragmented industry full of mom-and-pop outfits.
Sysco has a sterling dividend record (the payout has compounded by 18% per year over the past decade) and, at a 4% yield, the shares are as cheap as they've ever been. Companies such as Sysco and Philip Morris International are in the dividend sweet spot, offering a combination of relatively high yield (4% to 5%) and the prospect of being able to boost their dividends by 10% or more annually.