Consumer product companies trade at relatively high valuations with P/E ratios in the 20s. This is despite the fact that these companies aren’t really growing their profits that quickly if at all. The reason for this is that consumer product companies have extremely stable businesses. Furthermore, they consistently pay dividends to their shareholders.
In fact, the three companies I mention here have been paying dividends for over a century! They have done so through two world wars, the Great Depression, the banking panics of 1907 and of 2008, the Cold War, recessions, commodity shortages, and so on. So while their stocks may be overvalued, and while they may go down, you can be pretty sure that four times a year you will receive a dividend payment from them if you purchase their stocks.
1. Procter and Gamble (NYSE:PG)
Procter and Gamble is the poster child for “widows and orphans” investing. The company has been around since the 1800s creating and selling consumer goods. It is one of the largest companies in the world and it owns some of the leading brands from Gillette, Crest, and Swiffer. These are products that people need to buy even if they have very little money to spend. Therefore Procter and Gamble has been performing relatively well despite the fact that the economy has been weak.
The stock currently trades at 22 times earnings, and it isn’t growing these earnings due to a strong U.S. dollar hurting international profits, and strong commodity prices that have led to an increase in input costs. Nevertheless the company has strong margins and several stable income sources. While the stock may be expensive it is expensive in a market where certainty and stability trade at a premium, and any weakness can be purchased.
2. Colgate Palmolive (NYSE:CL)
Pretty much everything I said about Procter and Gamble can be said about Colgate. This company has been around for more than 200 years, and it has been paying a dividend for 119 consecutive years. It produces well known consumer products, must notably Colgate oral care products and Palmolive skin care products.
While profits have been steady, sales have been growing organically. The weakness has been due to one-time items, as well as a strong U. S. dollar and rising commodity prices. Nevertheless the company has strong and stable profit margins, and it can amply cover its dividend, and even raise it. Unfortunately this success comes at a premium price — the stock trades at 28 times earnings as investors are confident in the company’s growth potential in emerging markets. This valuation is too rich for me, but the company is as stable as a bond, and so it probably should be valued as such.
3. Church and Dwight (NYSE:CHD)
This is the smallest of the bunch, but it has also been the best performer during the 21st century. In fact since the 2000 peak in the stock market the stock is up eight-fold. That is from before the stock lost nearly half of its value in a few short months. The company makes well-known products such as Arm & Hammer baking soda and Trojan condoms.
The company is the only one of the three here that hasn’t been paying a dividend since the 19th century — its streak only goes back to 1901. Still, this is an impressive streak. The company pays the smallest dividend of the group at 1.8 percent, although this is in line with the aggregated dividend of the S&P 500. The company also has room to raise this dividend.
While the company didn’t grow its earnings in the first quarter of this year, this is an exception to the rule — profits have tended to rise like clockwork over the past several years. As a result the stock trades at about 25 times earnings. This, again, is rich, but considering the regularity with which we can expect the company to generate profits and pay dividends, the market is content to assign this premium valuation to the shares. As with the other two stocks I would prefer to wait for a pullback.
Dividends are essential to successful portfolio construction, but we need to perform due diligence on these companies all the same. From an earlier post, here are a few tips for picking the winners that will provide you with income for years to come:
1. Know how a company is paying for its dividend
Companies can get the cash to pay dividends from all sorts of sources. Some of these sources indicate that the dividend may not be sustainable or that it is not the product of value creation. There are several companies that have paid dividends by issuing stock or by borrowing money.
For instance one of the most popular dividend paying stocks among income investors is Kinder Morgan Energy Partners LP (NYSE:KMP). If you look at the company’s earnings per share, and then if you look at its dividend payout, you’ll quickly see that in most quarters the company hasn’t made enough money to pay its dividend. For instance in the most recent quarter Kinder Morgan’s EPS came in at $0.67 per share, but it paid $1.38 per share in dividends. The additional money had to come from somewhere. It turns out that the company issued nearly $1 billion worth of debt, and the average number of shares outstanding in the first quarter increased by 8 million versus the prior quarter. This indicates to me that Kinder Morgan’s dividend is not coming from profits. Rather it is coming from capital raises.
On the other hand consider a company such as Microsoft (NASDAQ:MSFT). Microsoft earned $0.78/share in the quarter ended December 31, 2013, but it paid just $0.28/share in dividends. This is a sustainable dividend coming from profits. This is the sort of dividend you should look for when constructing an income portfolio.
2. Bigger isn’t necessarily better
Just because a dividend-paying stock pays a very large dividend doesn’t mean that it is better than one that pays a smaller dividend. When you analyze a company that pays a large dividend, you have to ask yourself not just where the money is coming from, but why the dividend is so large. After all, if a large dividend is such a reliable income source, then why haven’t investors bid up shares of the company so that the dividend yield is smaller?
A large dividend can often mean that investors are uncertain that the company will be able to continue to pay it. Consider, for instance, the mortgage REIT Annaly Capital (NYSE:NLY). This stock paid a dividend of about $0.65 per share every quarter a couple years ago, and yet the stock traded at just $18 per share. This meant that the dividend yield was near 15 percent! But had you bought the stock simply because it paid a high dividend you would have lost money — the stock now trades at $11 per share. Furthermore, the company only pays $0.30 per share now.
Going back to the example of Microsoft, this company has paid a dividend of roughly 2 to 3 percent over the past several years, depending on the share price at a given time. The stock has been steadily rising, and so has the dividend.
These two examples show that a small, high quality dividend is superior to a large, low quality dividend.
3. Look for dividend growers
The best dividend companies to own don’t just pay a regular dividend, but they grow their dividends on a regular basis. A company grows its dividend when it grows its profits, and when management believes that this growth is sustainable. Over a long period of time buying companies that grow their dividends can make you a lot of money, even if they are fairly boring companies. For instance a company like Exxon Mobil (NYSE:XOM) isn’t a very fast growing company, but it has been a slow growing company for a long period of time, and it has increased its dividend every year for several decades. Over the past twenty-five years Exxon Mobile has grown its dividend five-fold, and still the company pays a dividend that can be covered several times over by its earnings. This sort of steady long term dividend growth can compound dramatically if you are investing now in order to pay for something in the future such as college tuition or retirement.
Picking quality dividend stocks isn’t easy. One way to pick quality dividend stocks is to be just as discriminating as you would be with any other investment. If you know how a company is paying for its dividend and are confident that it can continue to pay it, and even grow it, then you probably have a winner.
Disclosure: Ben Kramer-Miller is long Exxon Mobil.