2023-06-29 07:00:00 ET
Summary
- As my readers know, I’m no market timer, I’m a value investor.
- Regardless of what Fed Chair Jerome Powell is telling us, I’m confident that the rate-hike cycle is going to end (sooner rather than later).
- When that happens (rates pause indefinitely), dividends should compress (go lower) and shares should move back to normal valuation levels.
This article was published at iREIT® on Alpha on Wednesday, June 28, 2023.
What defines a quality stock?
I would love to get your feedback in the comment section below, and as David Van Knapp wrote on Seeking Alpha over nine years ago (emphasis added):
“After reviewing everything, my conclusion is that quality is in the eye of the beholder . My own view is that many fundamental factors could be deemed to indicate quality in a company. Selecting different factors results in different lists of stocks.”
As for me, I always look for a quality rating that is average or better, especially in the current market cycle. As an income-oriented investor, I obviously look for companies that pay dividends and much of my analysis is rooted in dividend safety and dividend growth.
Why you ask?
Dividends play a significant role in returns that investors have received during the past 50 years.
For example, going back to 1960, 69% of the total return of the S&P 500 Index can be credited to reinvested dividends and the power of compounding, as illustrated below:
Over a longer period (1930-2022), you can see (below) that dividend income’s contribution to the total return of the S&P 500 Index (SP500) averaged 41%. By this more granular analysis, you can see that the S&P 500 Index performance on a decade-by-decade basis varied greatly from decade to decade.
Breaking it all down even further, you can see that dividends played a large role in terms of contribution to total returns during the 1940s (67% contribution), 1960s (30% contribution), and 1970s (73% contribution) - decades in which total returns were lower than 10%.
Alternatively, dividends played a smaller role during the 1950s (30% contribution), 1980s (28% contribution), and 1990s (16% contribution) when average annual total returns for the decade were well into double-digits.
And during the 1990s (16% contribution), dividends were de-emphasized. That’s because most companies were deploying capital into their businesses, not returning dividend to shareholders.
From 2000 to 2009, a period often referred to as the “lost decade,” the S&P 500 Index produced a negative return. Largely as a result of the bursting of the dot-com bubble in March 2000, stock investors once again turned to fundamentals.
Based on a study by Ned Davis study, companies that don’t pay dividends or cut their dividends suffered negative consequences.
As seen below, dividend non-payers and dividend cutters and eliminators (e.g., companies that completely eliminated their dividends) were more volatile (as measured by beta and standard deviation) and fared worse than companies that maintained their dividend policy.
In contrast, companies that grew or initiated a dividend experienced the highest returns relative to other stocks since 1973—with significantly less volatility.
The Margin of Safety
Now that you know how I define quality, let’s move on to another critical part of the investing world: valuation. As Chuck Carnevale said ,
“I agree that it's important to invest in quality, I also believe that you can pay too much for even the best of companies.”
Chuck Carnevale and David Van Knapp are both mentors, as I have learned how to become an intelligent investor only after studying their work on Seeking Alpha for over a decade now. I’m forever grateful for the hundreds of articles they’ve published and I ‘m sure manty others feel the same.
“If you were to distil the secret of sound investment into three words”, wrote Benjamin Graham in Chapter 20 of The Intelligent Investor , “we venture the motto, MARGIN OF SAFETY.”
I’ve encouraged all of our interns at iREIT® on Alpha to read the book, for it's perhaps one of the most important books on investing.
In the simplest terms, the margin of safety is the difference between a stock’s price and its intrinsic value. When a stock’s price is below its intrinsic value, the greater the margin of safety against future uncertainty and the greater the stock’s resiliency to market downturns.
As Howard Marks (another one of my mentors) puts it (in The Most Important Thing ):
…most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high-quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them….Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.”
So without further ado, let me provide you with some terrific Dividend Kings to put on your shopping list…
Dividend King #1 - Johnson & Johnson ( JNJ )
Johnson & Johnson is a healthcare giant that was founded back in 1886. JNJ has a market cap of $457 billion.
The healthcare sector was one of the top performers in 2022, but that has not been the case in 2023, as JNJ shares are down nearly 10% to date.
The company recently went through some changes, in which they spun off their popular consumer health segment into a new public company called Kenvue Inc. ( KVUE ). JNJ still owns roughly 90% of the new company at this time.
Johnson & Johnson has long been a very diversified business, breaking out the following segment:
- Consumer Health (now Kenvue)
- Pharmaceuticals
- MedTech (formerly Medical Devices).
However, all three segments had grown into sizable standalone businesses, and management thought the spin off would not only unlock shareholder value, but also allow for great focus on the specific segments.
Here is a look at the segment revenues as of 2022, the last full year with all three segments.
- Consumer Health: $3.8 billion
- Pharmaceutical: $13.2 billion
- MedTech: $6.8 billion.
The pharmaceutical segment has long been the backbone of the company, being the largest segment with a loaded pipeline to continue holding the torch moving forward.
MedTech is expected to return to growth after years in which we saw muted surgical procedures due to the pandemic, but with things returning to normal, this could be an area for growth once again.
Being in the pharmaceutical space brings plenty of legal expenses, but the largest expense right now for the business has been related to the consumer health segment, with their talc-related baby powder.
In April of this year, it was reported that the company was in talks regarding an $8.9 billion settlement, which would be paid out over a 25-year period. Although the litigation relates to the consumer health segment, JNJ is still responsible for the legal expenses.
Once that gets resolved, it will certainly be a relief for many investors, allowing them to look forward without the cloud hanging over the stock.
When it comes to the dividend, JNJ is a dividend king for having increased its dividend for 61 consecutive years. The company’s dividend currently yields 2.9%, with a low 44% payout ratio and a five year dividend growth rate of 6%.
Shares of JNJ currently trade at a forward earnings multiple of 15.3x, which is below their five & 10 year historical average earnings multiple of 17.2x.
Dividend King #2 - Federal Realty Investment Trust ( FRT )
Federal Realty Investment Trust is a diversified real estate investment trust, or REIT, that owns and manages community and neighborhood shopping centers.
FRT currently has a market cap of 7.6 billion. Over the past 12 months, with interest rates climbing higher, the stock is down 6%, with all of that downside coming in 2023, where the stock is down 8.5%.
FRT is a diversified REIT with a focus on retail, and, more specifically, having a grocery component within its properties. In fact, nearly 75% of their portfolio has a grocery component.
Federal Realty Investment Trust was founded in 1962, and they currently have a portfolio that consists of 102 properties that are leased out to roughly 3,200 tenants.
The REIT is a component of the S&P 500 and one of the few REITs on the prestigious dividend aristocrat list, and the ONLY REIT on the dividend kings list.
FRT currently yields a dividend of 4.7%. They have grown their dividend for 55 consecutive years, which is the longest streak by a REIT, by a wide margin.
Being that the company was founded back in 1962 and has been able to raise their dividend with a 55-year CAGR of 7%, shows the strength of the company’s portfolio. Since 1962, the U.S. economy has been through a number of different economic cycles, but one thing has remained consistent, and that has been the FRT rising annual dividend.
As you likely know, when we look at REITs we do not focus on EPS. Instead, we focus on either FFO (funds from operations) or AFFO (adjusted FFO), which is adjusted funds from operations. Being in real estate and owning properties, depreciation is a huge expense for the sector, which drastically brings down EPS. So, instead, REIT investors focus more on operating income, which is similar to FFO and AFFO.
Analysts are looking for AFFO of $4.92 in 2023, which equates to a 2023 AFFO multiple of 18.7x. Over the past five years, shares of FRT have traded at an average AFFO multiple of 24.4x and over the past decade closer to 28x, suggesting shares appear undervalued.
Dividend King #3 - Lowe's Companies, Inc. ( LOW )
Lowe’s Companies operates within a duopoly with The Home Depot, Inc. ( HD ) in the home improvement sector. Housing has been an interesting sector of late because data tells you high mortgage rates combined with low inventory has made buying a home especially difficult for first time homebuyers.
On the flip side, homebuilders have been soaring higher, with the SPDR® S&P Homebuilders ETF ( XHB ) up over 30% in 2023 alone. In addition, you have more than 60% of current homeowners sitting on mortgage rates below 4%, and even 3% in many cases, leaving very little incentive to sell.
So what gives?
Well, you may have more homeowners rethinking about relocation and instead looking to improve their current home, something that took place during the pandemic when work from home became a must.
Current homeowners not only have low mortgage rates, but they have loads of equity they could tap into for these home improvement projects. This benefits the likes of Lowe’s and even Home Depot.
In the latest earnings reports from both home improvement companies, they were both experiencing a slowdown, but Lowe’s actually outperformed HD, which was a major positive. Under the leadership of Marvin Ellison, former senior leader at HD, Lowe’s has made great strides into closing the gap with Home Depot, and it has been showing.
Q1 was a challenging quarter for the sector, as they dealt with declining lumber prices and high inflation, which impacted both sales and margins alike. The remainder of the year is expected to be stagnant before management believes the turnaround will come, making Lowe’s more of a long-term play.
Here is more of a detailed look at how the company did in Q1 2023:
Lowe’s is unique in the fact that they pay a dividend of 2%, which is about average for a dividend king, but what makes them unique is they are also a dividend growth company.
Over the past five years, Lowe’s management has increased the dividend at an average annual rate of 20%. Lowe’s has increased their dividend for more than 60 years.
Many companies on the dividend kings list are very mature, which typically coincides with slower dividend growth, similar to the first two dividend kings we looked at today.
In terms of valuation, analysts are looking for Lowe’s to generate EPS of $13.35 in 2023, which equates to a 2023 earnings multiple of 16.3x. Over the past five years, shares have traded closer to 19.2x, and over the past decade they have traded at an average multiple of 20x, suggesting shares appear undervalued at current levels.
In Closing…
As my readers know, I’m no market timer, I’m a value investor…
And regardless of what Jerome Powell is telling us, I’m confident that the rate-hike cycle is going to end (sooner than later)…
When that happens (rates pause indefinitely), dividends should compress (go lower) and shares will more back to normal valuation levels…
I don’t have a crystal ball, so I can’t tell you when this is going to happen…
But it will...
And hopefully you’ll be living the dividend dream with me.
Happy SWAN Investing!
For further details see:
Retire Rich With 'Dividend King' Royalty