A Top Dividend Growth Stock for 2014

This is the first in a series of four articles about stocks in the brand new edition of my eBook, The Top 40 Dividend Growth Stocks for 2014.

In this series, I will highlight:

  • A couple of iconic dividend growth stocks that have made it into the Top 40 all seven years that I have been writing the eBook since 2008; plus
  • Two other stocks that are not as well known, but which strike me as great dividend growth investments if you can get them at the right price.

Wherever I can, I will refer to the Lessons in Dividend Growth Investing that I wrote last year. I want to show you how theory gets translated to reality.

[ad#Google Adsense 336×280-IA]You probably need no introduction to Coca-Cola (KO).

It is a classic stock for dividend growth investors, a stalwart in many portfolios.

I recently bought my first shares.

I waited several years to grab them, because the recent combination of Mr. Market’s mood swings plus Coke’s announcement of their next dividend hike pushed Coke’s yield above 3%.

That is widely regarded as a good buying point for this fabulous company.

When I am selecting companies, I look at a variety of factors. I use some of them as screens, meaning that I simply eliminate companies that do not pass the screens. Screens are a great time-saver. They can help you winnow thousands of stocks down to less than 100 in just a few minutes.

As discussed in Lesson 3 on the five-year rule, one screen I use is that the company must have increased its dividends for at least five years straight. Coke passes this test with flying colors. Its most recent increase is its 52nd straight. JFK was president when Coke last went a year without raising its dividend. That was before the Viet Nam war and probably before many of you were born.

Another screen that I use is minimum dividend yield. I use 2.0% in my eBook, and for my personal investing I want to receive at least 2.5% to 2.7%. Again, Coke passes this screen easily. Even before its recent hike, it was yielding just under 3%, and after the hike it is at around 3.2%.

Yet another screen is the dividend growth rate. I require that both the most recent year’s dividend increase and the 3-year DGR (compound dividend growth rate) be at least 4% each.

All of these numbers are easy to find from David Fish’s Dividend Champions, Contenders, and Challengers list. Here is a little screenshot that shows the numbers for Coke.

As you can see, KO’s most recent increase at the time of the screenshot (in 2013) was 9.8%, and we know from a more recent announcement that KO will soon increase its dividend 9% more. We see the 3-yr DGR is 8.4%. In fact, if you look at the 5-yr and 10-yr DGRs, you can see that KO has been sending investors increases of a similar magnitude for a decade. That really is a fabulous record.

Here’s another screen that I use. I believe that it is important to write out a stock’s Story before I invest in it. I capitalize Story, because this is a special step.

What is a Story? It is a brief description of how and why the company makes money. It explains in simple language what the company does, why it’s been successful, and why it’s likely to be successful in the future. It identifies sustainable competitive advantages (often called moats) that help protect the company’s competitive position.

The Story is not a place for showing off your vocabulary or how clever you are. It is a place for simplicity. An intelligent 8th-grader ought to be able to understand the company’s Story and distinguish a good one from a bad one.

I follow a simple rule: If I can’t understand how a company makes money, and why it will probably continue to do so, I will not invest in it.

Here is an example of Coke’s Story from my eBook. You will note that I write in a simple direct manner and use abbreviations to save space. This is not an exercise in literature, it is an exercise in investing.

Story: World’s largest beverage company, with ~60% of revenue from outside USA. Brands include Coca-Cola (world’s most recognized brand name), Diet Coke, Coke Zero, Sprite, Fanta, Minute Maid, Dasani, Nestea, VitaminWater, and Powerade. Overall KO has 400 brands and 3500 products, including 14 megabrands with revenues >$1B each. Products sold in >200 countries through extensive network of independent and company-owned bottlers. Global distribution network is significant competitive advantage. Backs brands with continual and massive amount of advertising. About ¾ of sales are from outside North America. International expansion has been decades-long strategy. Globally, KO #1 in sales of sparkling beverages, juice, and ready-to-drink coffee and tea, #2 in sports drinks, and #3 in bottled water. Long-term vision is to double sales from 2009 to 2020, with much of growth coming from developing markets such as China, Russia, African continent, and India, as well as growth in emerging product categories. Huge cash hoard and ongoing share buyback program in addition to managed dividend policy. +12

The “+12” at the end is my rating of Coke’s Story on a scale of 1-15. I have never given a 15, and few companies score as high as 12. Coke is, quite simply, a great company.

After I winnow down the candidates with screens like those above, I score companies on more than a dozen metrics. Examples include earnings growth, revenue growth, return on equity (ROE), and debt. The dividend statistics that were used as screens are also scored. For instance, Coke’s 52 years of dividend increases garners 8 points, its 3.2% yield would be worth 4 points, and so on. All of the metrics are easy to find on free sites like Morningstar, or they are in the Dividend Champions document referred to above, which is also free.

As you can see by now, companies rack up points on my scoring system, and that is how I separate the wheat from the chaff. When I rated KO this year, it had a Company Quality score of 66. It is the 5th-highest rated company in this year’s Top 40. It is truly a great company.

But wait! There’s more! I do not only score each company’s quality, I score it again on Valuation. My approach to valuation is a simple two-step process.

Step 1: Look at Morningstar and see how many stars they give the stock. Here is Coke:

Morningstar uses a 5-star system that conveys what they think about a stock’s current price compared to its fair value, which they compute using a complex mathematical model. A 5-star stock would be highly undervalued, which means it is selling at a great price. A 4-star stock is selling at a good price. In other words, Morningstar is saying that they think Coca-Cola is selling at a good price right now.

That is reinforced by the observation earlier that, for years, dividend investors have considered Coke to be a good buy if you can get it a yield of 3% or more. Recall from Lesson 6 that in the calculation Yield = 12 Months’ Dividends / Price, if price goes up then yield goes down, and vice-versa, like a see-saw. So a lower (better) price also brings a higher (better) yield. In Coke’s case, the combination of its new dividend payout and a relatively low price combine to get you a better yield right now of about 3.2%.

Step 2: I look at FASTGraphs. (Buyers of my eBook get free access to FASTGraphs for all 40 stocks.) With FASTGraphs, you get a picture of the stock’s price plotted against a “true-worth” line, which means fair value. The underlying idea is the same: Is the stock a bargain or fairly valued right now, or is it too expensive? FASTGraphs draws a fair value line by using a standard P/E (price-to-earnings) ratio applied to the company’s current and projected future earnings.

From this chart, KO appears overvalued, meaning that it is not worth its price. You can tell that, because its actual price (the black line) is several dollars above its “fair” price (the orange line). That said, notice the orange caption to the right of the chart. That says that KO is valued at a price-to-earnings ration (P/E) of 15. That’s where the orange line has been drawn, at 15 times KO’s known and estimated future earnings.

But KO “always” trades at a higher P/E. How do we know that? We can graph it on FASTGraphs, which on a historical graph displays the “normal” P/E for any stock.

When we do this, we see that Coke’s P/E, for the last 15 years, has had a “normal” value of 22, not 15. Look at the blue line and the blue caption to the right of the following chart for that information.

As you can see, KO’s current price (the black line) is below its normal valuation (the blue line).

Why might KO “always” be overvalued? Because it is a great company. Investors have been willing to pay a little more that usual to own a piece of a company that is reliable, predictable, and sends them rising dividends every year.

My interpretation of this information is that Coca-Cola is trading at no worse than its fair value right now. Indeed, it might be a little undervalued. That assessment, combined with its new 3.2% yield, makes it a “buy” for me. And in fact I recently purchased shares of KO for both my public Dividend Growth Portfolio and for my wife’s and my retirement portfolio.

My writing colleague here at Daily Trade Alert, Jason Fieber (a.k.a. Dividend Mantra), also recently purchased shares of Coke. The article that he wrote about his purchase can be found here. I recommend it, as he did a good job of dissecting Coke’s recent peformance and drawing logical conclusions from his analysis.

I am a long-term investor. Every stock that I buy, I intend to hold for years if not decades. I expect each one’s income to help pay for my retirement. Coke’s recent price flatness, which has pulled its valuation into fair territory and allowed its yield to float above 3%, is a gift from the market. I was happy to purchase Coke recently, and I hope that in the future, when I have more money to invest, the market cooperates again and presents the shares at a fair value.

Coca-Cola (KO) has been in my Top 40 every year since I began writing about dividend growth investing, and I have no reason to think that it will not “make the list” for many years to come.

Dave Van Knapp
Author of Top 40 Dividend Growth Stocks