Last January, I kicked off a new series for Daily Trade Alert called Dividend Growth Stock of the Month. Since then, I have presented 11 stocks for your consideration, including the most recent, Microsoft (MSFT), earlier in November.
But the very first stock I wrote about, back in January, remains one of my favorites. In fact, I bought shares of it twice in January, adding to a position that I first started in 2009 and 2011.
The trigger for my shopping trip was that the dividends accumulating in my portfolio reached $1,000.
That’s how I run the portfolio: I let incoming dividends from all my stocks pile up, and when the total hits $1000, I go shopping.
The stock is AT&T (T).
With the most recent purchase, I now own 177 shares of T, and it comprises 7% of my portfolio.
Why have I bought AT&T 3 times this year? Why have I allowed it to grow to 7% of my portfolio? Let’s explore those questions.
AT&T’s Dividend Characteristics
What jumps out from this summary is that two categories are dark green (very good) and four categories are light orange (questionable).
Let’s look at the green categories first. AT&T’s yield, at 5.6%, is among the highest that you can find among dividend growth stocks. In fact, it is the second highest yield among all Dividend Champions – stocks with increase streaks of 25 years or more. The average yield of all Champions is 2.7%, which is less than half that of AT&T.
The second green category is the length of AT&T’s streak of increasing its dividend: 31 years. I consider anything over 25 years to be excellent. Many of you reading this were probably not even born yet when AT&T began increasing its dividend every year in 1984.
The three bottom lines in the table concern the size of AT&T’s annual increase. For several years, T has been raising its dividend by $0.01 per quarter, which is $0.04 or about 2% per year.
That’s not very fast growth. The average Dividend Champion’s 5-year dividend growth rate is 7% per year. So AT&T falls neatly into a certain category of dividend growth stock: high yield, slow growth.
As a dividend growth investor, I like to have a mixture of dividend characteristics in my portfolio. I consider that to be a healthy form of diversification. (For more on that subject, see “Dividend Growth Investing Lesson 16: Diversification.”)
So I own stocks across a spectrum of yields and dividend growth rates. AT&T has a high yield but grows its dividend slowly. By comparion, Microsoft has a low-ish yield (2.7%) but sports a 5-year dividend growth rate of 17% per year. I happily have spots for both in my portfolio.
A stock like AT&T offers a clear tradeoff: You get a much higher yield to begin with, but the dividend has been growing pretty slowly. Whether you like that tradeoff is purely up to you. No one can tell you whether AT&T is “better” than, say, Microsoft. They simply have different characteristics. What’s good for me may be different from what’s good for you.
In the short term, I will get more dividend dollars per share from AT&T. Long term, at some point in the future, the annual dollars from Microsoft will surpass those from T.
I can illustrate this using the cool calculator at Miller/Howard Investments. It allows you to compare two stocks with different dividend characteristics like T and MSFT. In this screenshot, the blue stock is AT&T and the orange stock is Microsoft.
As you can see, the crossover point is 8 years: Until that year, AT&T feeds more dividends into my portfolio than Microsoft. Year 8 is about equal, and after that Microsoft will deliver more dividends each year, and at an increasing rate. (The dollar figures are multiplied by 10: The calculator requires an initial “investment” of $10,000, while I just invested $1,000.)
But caution: The calculation for Microsoft assumes that it can maintain its 17% per year dividend growth rate indefinitely. That is probably impossible; I don’t know of any company that has done it. So the graph can be misleading if you just project unsustainable growth rates into the future.
It is instructive to see the comparison and to understand the dynamics of fast dividend growth rates, but in your own planning, be realistic. As I said earlier, the average 5-year dividend growth rate for all Dividend Champions is 7% per year, not 17%. If I had to guess, I would say the crossover point in dividends per year will be more like 10-12 years out, not 8 years. As time goes on, MSFT’s dividend growth rate will almost certainly slow down.
The final category in the first table is payout ratio. That is the ratio of dividends paid per share to earnings per share. T’s payout ratio of 94% is high. But for a capital-intensive business like AT&T, it is probably sustainable. As you can see here, T’s payout ratio, quarter-by-quarter, has usually been high for the past 10 years. Sometimes it has even surpassed 100% on a temporary basis.
So while AT&T’s payout ratio is high, I do not think that is a major concern.
AT&T’s quality as a company has not changed much since January’s article. It is still solid.
As you probably know, they completed their purchase of DirecTV since then. Some people like this acquisition, others do not. I am hopeful about it. I generally like the strategic possibilities of combining DirecTV’s content with AT&T’s distribution capabilities. It remains to be seen whether or how much AT&T can capitalize on the potential combination of the two.
So my main focus in deciding on whether to buy more AT&T came down to its valuation.
I describe how I value stocks in Dividend Growth Investing Lesson 11: Valuation. The idea is to interpret how a stock’s actual price compares to what it “ought” to be based on its current financial situation and growth outlook.
I use a 4-step process.
Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value. The default estimate is based on a price-to-earnings ratio (P/E) of 15.
As you can see, AT&T’s actual price (the black line) is about 17% below its fair value (orange line) when calculated by this method. That is a good valuation for potential buyers. You always want to buy stocks at a bargain if you can.
Step 2: FASTGraphs Normalized. The second valuation step is to compare AT&T’s price to its long-term average P/E ratio. For this comparison, I chose a 10-year period to represent AT&T’s “normal” valuation.
By this approach, AT&T is 11% undervalued. That is a little less undervalued than we saw above. The reason is that over the past 10 years AT&T’s average P/E valuation ratio has been 14 (see the blue box in the right panel of statistics) compared to the first chart’s use of 15. Nevertheless, this method still suggests that AT&T is slightly undervalued.
By the way, in both of the FASTGraphs, you can see AT&T’s slowly rising dividend, which is shown by the gray line on the charts.
Step 3: Morningstar Star Rating.
The next step is simply to see how Morningstar rates the stock. Unlike their mutual fund ratings, which are based on past performance, Morningstar’s stock ratings are based on valuation.
On Morningstar’s 5-star system, AT&T gets 3 stars, meaning that they believe that the stock is fairly valued. They assign a fair value of $33 to the shares. The price I got it at was $33.68. Close enough.
Step 4: Current Yield vs. Historical Yield.
Finally, we compare the stock’s current yield to its historical yield. It is better to be near the top of that range than the bottom.
According to Morningstar, T’s average yield over the past 5 years has been 5.4%. With its current yield of 5.6%, the stock’s current yield is just slightly above its 5-year average. That suggests that the stock is about fairly valued. The market is pricing AT&T’s dividend about the same as it has over the past 5 years.
Using the 4 approaches just described, our valuation summary for IBM looks like this:
You can see why I added more shares of AT&T to my portfolio. It is a high-quality company with an excellent dividend yield, albeit one that grows slowly. It was available at a fair valuation, so I grabbed it.
The 30 new shares will add $56 to my Dividend Growth Portfolio’s income over the next 12 months, not counting the probable 2% increase in February.
That $56 may not sound like much, but it is another brick in the wall of getting my portfolio to generate the income that I want by the time I start using it for retirement. The amount will compound over the years to keep me ahead of inflation.
Even ignoring increases and compounding, my “raise” from this purchase represents about a 1.6% bump in my income immediately. As an old boss of mine used to say when questioned about a pay raise, “David, it’s better than a kick in the ass.”
– Dave Van Knapp