The Power of Dividend Growth Stocks
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Dividend growth stocks are those which accumulate several years, or even many decades, of consecutive dividend increases year after year. Different academic studies have shown that these kind of companies tend to outperform the indexes over the long term, especially in times of economic uncertainty and volatile stock prices.
It's not too difficult to understand the reasons behind this outperformance, after all, if a company generates enough cash flows to permanently increase its dividend payments, that's probably a reflection about its fundamental strength and competitive position. Furthermore, dividend growth stocks provide many benefits from an analytical perspective.
Dividends can be a very intuitive and transparent valuation tool, and investors can compare a company's dividend yield versus the yield offered by its competitors. Keeping an eye on the historical evolution of those variables can provide some interesting insights about the attractiveness of different companies as investment opportunities.
Two classic rivals in the soft-drink market are Coca-Cola (NYSE: KO) and Pepsi (NYSE: PEP), and we can get some valuable information about the relative valuations of these two competing giants by analyzing their dividend yields from a historical point of view. While Coke used to have a higher dividend yield a few years ago, the situation is now reversed, and Pepsi yields a higher 3.1% versus 2.7% for Coca-Cola.
Although Coke has delivered a slightly higher increase in dividends than Pepsi over the last five years, the change in dividend yield is much more related to price changes than dividend growth over that period. As we can see, shares of Coke have clearly outperformed Pepsi in the period under analysis.
Coke increased its market share in soft drinks versus Pepsi, and that is one clear explanation for the relative price change. But investing is about the future, not the past, and Pepsi certainly has some very interesting opportunities in snack foods and healthy products which should fuel growth over the following years.
The importance of the snack business for PepsiCo should not be underestimated; capitalizing on the strength of its brands and its gigantic distribution network, the company is the biggest producer of snack foods in the world. In fact, snack foods is Pepsi's most profitable business, generating 24% of the company's sales but a much higher 41% of operating profits as of last year.
The company's CEO, Indra Nooyi, has implemented some strategic decisions which have promising perspectives when it comes to growth possibilities. Pepsi has been strongly focusing on its more healthy products; and brands like Gatorade, Tropicana and Quaker Oats are showing strong growth due to changing consumer habits towards products with better nutritional characteristics.
Pepsi lost market share in carbonated drinks versus Coke, but the company still has many growth opportunities in other business segments, so investors may want to consider the current low valuation as a possibility to acquire some Pepsi shares at a tasty dividend yield.
When a company has a solid trajectory of dividend increases, and the investor believes those dividends will keep growing in the future, the decision to buy the dips in stock prices can be easier to implement due to the transparency provided by dividend payments.
Industrial conglomerate 3M (NYSE: MMM) has increased its dividend payments through 55 consecutive years, which makes it one of the most outstanding dividend growth stocks an investor can buy. Being exposed to the business cycle, shares of 3M where hit hard during the last recession, but history teaches that buying solid companies in times of excessive negativity can be one of the most profitable strategies in the long term.
In fact, during the last recession shares of 3M fell so much that they were yielding a historically high dividend yield of 4%. Dividends are more stable than earnings, especially in the case of a business with time proven dividend growth policies, so it would have been much easier to identify an opportunity in 3M by observing dividend yields instead of ratios like the P/E which can be more affected by economic conditions. The last recession was, in fact, a great opportunity to buy 3M at an unusually high dividend yield.
3M has a very strong balance sheet, and the company is widely diversified both in terms of geographic markets and business segments. Furthermore, its management has proven its ability to produce positive free cash flows even under the heaviest headwinds during the last financial crisis. An extraordinary trajectory of dividend growth, combined with a remarkable financial soundness make of 3M a solid dividend stock for the following years.
Speaking about dividend yield as a tool to identify buying opportunities in dividend growth stocks, it may be time to take a close look at Exxon (NYSE: XOM), since the company is approaching the 3% dividend yield zone, which was a great buying opportunity last year. Thanks to its growing dividend, investors in Exxon didn't need such a sharp price decrease in order to see an increase in dividend yield on this occasion.
A rock solid bellwether among big integrated energy companies, Exxon has achieved 30 consecutive years of growing dividends in April of this year, and the firm honored its history by announcing an outstanding 21% dividend hike for that quarter. Energy prices can be volatile and affect the company's earnings, but it would take much more than a typical recession to derail Exxon from its long path of dividend increases.
After the acquisition of XTO, Exxon has gained a privileged position in management skills and specific know how when in exploration of unconventional resources. Exxon is well known for its selectiveness when it comes to choosing investment projects. This may mean slower growth in earnings as the company lets some opportunities pass, but at the same time it guarantees profitability and cash flow generation due to the superior quality of its projects.
Exxon has levels of return on its investments which are well above industry averages, and its financial strength leaves little room for doubt. One of the last remaining AAA rated firms in the world, Exxon has a strong cash position and access to cheap financing if considered necessary. The company´s dividend payout ratio is at a very sustainable 23%, which leaves ample room for dividend increases in the future.
Investors looking for ways to beat the markets with a simple but powerful and time proven strategy can find in dividend growth stocks a fertile ground in the search for opportunities. Especially when markets are feeling worried about the economic scenario and valuations become much more attractive.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of The Coca-Cola Company, PepsiCo, and ExxonMobil. Motley Fool newsletter services recommend 3M Company, PepsiCo, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.