MKC:CC - Dump Alert: 3 Dividend Aristocrats Which Are Awful Investments

2023-11-03 09:38:49 ET

Summary

• The worst thing dividend investors can do is settle for low-yield and low-growth dividend stocks.
• Doing so will lead to subpar income generation.
• These are 3 high-quality aristocrats which do not deserve a spot in your portfolios.

Written by Sam Kovacs.

Introduction

With jobless claims coming in higher than expected last week, we can quite confidently say that the Fed will not raise rates this month. Of course, it is even more unlikely that they'll reduce the rates, which means most likely that we're going to see rates remain flat in November, which will be the longest amount of time that rates have remained high since the Fed started raising rates in 2022.

This means that rates have likely peaked, but will stay at this peak for a while. The whole "higher for longer" scenario.

Every time the Fed keeps rates flat, it sends a signal to the market that rates have likely peaked.

This is my opinion. As the market decides that rates have peaked, we'll likely see a larger move into fixed income. After all you want to buy bonds when yields are at their highest, to avoid further declines in prices as rates and yields increase more.

During the past week, we might reasonably ask: have yields peaked?

Provided the Fed doesn't hike its rates again, and inflation continues to tame, the answer will be: probably.

This, of course, is expected to cause a move between equities and fixed income.

With the recent decline in stocks with the S&P 500 (SP500) dipping to 4,115 you could argue that this has already happened. After all, for prices to go down you need more sellers than buyers, and it's possible movement between stocks and bonds was happening.

I'm primarily an equity investor, and in that regard purely a dividend growth investor.

This means that I focus on companies which pay enough dividends by the form of current yield and future growth, to provide a long lasting, meaningful stream of dividend income.

To achieve meaningful income, there is always a trade-off between yield and future dividend growth.

Over a certain time period, there is a tipping point where a high yield with low growth would provide the same income in year x than a low yielding stock with a higher yield.

This means that from an income generation perspective, you can be successful investing in high quality stocks with high yields and little to no growth, low-yielding stocks with high growth, or mid-yielding stocks with mid growth.

What you cannot invest in are stocks which have low yields, and which do not grow their dividends at a sufficiently fast rate.

Many such stocks exist, because they are not being valued on their ability to generate and pay dividends to their shareholders but on other factors, which is fine.

They are often fine businesses. In fact, I've owned 2 of the 3 dividend aristocrats which I'm going to be presenting in today's article.

But in today's environment, these stocks are unlikely to do well, or be good dividend investments: if investors continue to favor fixed income over equities, certain equities will be worse off than others.

Those which stand to perform the worst for dividend investors are the low yield, low growth stocks.

What you need to remember is this: the best way to sleep well at night as a dividend investor is to ensure that you'll be able to reach your financial goals from dividends alone.

One day, you'll retire and hopefully live off of the dividends from your portfolio.

Equity prices become secondary here. Of course, you buy when cheap, and sell when high, but this becomes just another way to ensure you surpass your goals.

When you're buying stocks which have low yields and low growth, the income alone won't be important enough to meaningfully support your retirement goals, so you'll need to rely on capital gains.

If you happen to miss the top in a stock because you think it can only go up, or conversely you retire as the market crashes, your capital gains go up in steam.

Here are 3 such stocks which you should avoid.

3 Dividend Aristocrats to dump

Aflac Incorporated ( AFL ) trades at $79 and yields 2.15%. It has been doing very well with the price more than doubling from its pandemic lows.

Between 2021-2022, I acquired shares in Aflac at an average cost of $52-$55.

But the dividend growth this year was disappointing. And when I look at the results, even if they beat analyst estimates, I find myself asking how it will return to further growth.

This year the dividend grew just 5%, and even if it returned to 9% to 10% growth, $80 is the clear level at which investors would want to sell.

You definitely wouldn't want to buy shares at this level, which is close to all-time highs for AFL in relation to its dividend. While the upside is maybe an extra 10%, the downside is a potential 25-30% decline.

Assume the dividend continues to grow at 5% per annum, and you invest $10,000 today and reinvest dividends 10 years from now, you'd expect $437 in annual income, which is just 4.37% of the initial investment. Not great.

This is a clear case of a stock which seems unlikely to provide strong dividend growth going forward despite its low yield, and which seems stretched in terms of valuation.

Buy low, get paid to wait, sell high. Now is the time to sell. Farewell Aflac, will reconsider when your price, and/or dividend have considerably changed.

Another such stock is General Dynamics Corporation ( GD ).

GD trades at $241 and yields 2.2%.

Unlike Aflac, GD looks fairly valued on the DFT Chart, but investors should remember that the dividend growth rate has been declining throughout the past decade, which needs to be taken into account when analyzing GD as an income investment.

While the dividend has grown at a 9% CAGR over the past decade, this has declined to a 7.3% CAGR during the past 5 years and a 4.8% increase this past year.

It is common with aristocrats that, as they mature, it is harder to maintain high dividend growth indefinitely, as the bar increases exponentially due to the compounding nature.

This is, of course, not fundamentally the fault of the business, it is simple mathematics, but given that the mathematics will determine whether we have more or less dividend income in retirement, we might want to pick stocks where the math is in our favor!

Assuming a 5% growth rate going forward, GD would have similar income potential as the simulation we ran for Aflac above, and, therefore, should be avoided.

As you can see with GD's 3rd quarter results, the big problem they're facing is that their increases in revenues are not offsetting their increases in costs, which are pressuring operating margins and EPS downwards despite higher revenues.

This is a trend which makes it difficult to return to sufficient dividend growth for the yield.

It is a business which is well run and will be around for a while, there just isn't a clear-enough path to growth for income investors to get excited.

The final stock we'll look at today is McCormick & Company, Incorporated ( MKC ). MKC has dropped to prices which have given it 10-year-high yields. It now trades at $64 and yields 2.45%.

This won't be enough to get me excited, as last year the dividend increased just 5%, below the 8% CAGR experienced over the past 5 and 10 years.

When we look at MKC's outlook for 2023, it becomes clear that it is unlikely that we'll see the firm announce much more than a 5-6% dividend increase this year, in line with the EPS growth.

Even if we assumed 7% growth for MKC, we wouldn't be looking at a very attractive dividend growth opportunity.

If you invest $10K in MKC and assume a 7% dividend growth rate, and you reinvest dividends, then 10 years from now you'd expect $607 in annual income, or 6% of your original investment.

This remains subpar, and dividend investors should not buy this stock despite the recent selloff.

In fact, if you own McCormick & Company, it is likely a good idea to sell and replace it with something which is a better value and offers better growth.

In today's market, options abound.

Conclusion

In an equity market which has been challenged by higher rates, dividend investors really do not need to settle for companies which are not growing the dividend at sufficient rates.

Settling will rob investors of their full income potential, and why leave money on the table?

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