Note from Daily Trade Alert: As long-time readers are aware, Dave Van Knapp is a highly-respected authority in the dividend growth investing (DGI) space. He wrote our Dividend Growth Investing Lessons. Since 2008 Dave has maintained and made public a real-money Dividend Growth Portfolio. It demonstrates the results available from a sound dividend growth strategy. Dave alerts us whenever he makes a significant change to the portfolio, such as the following article…
This is the second in a series of four articles about the 40 stocks in the most recent edition of my eBook, Top 40 Dividend Growth Stocks for 2014.
In the first article (click here) I discussed why Coca-Cola is in this year’s Top 40 for the 7th straight year. In two future articles, I will reveal the names of two lesser-known stocks that are also in this year’s Top 40.
In this article, let’s talk about a second iconic dividend growth stock: Procter and Gamble (PG). This is another company that, like Coca-Cola, is a stalwart in many dividend growth portfolios.
I recently purchased shares of PG for my public Dividend Growth Portfolio. This article explains the reasons that I did that. I have a two-step process in evaluating a company for purchase.
Step 1: Company Quality
Why is PG a classic dividend growth company? Because it has so many of the qualities that dividend growth investors seek. Let’s talk about some of them.
- A long streak of annual dividend increases. PG has raised its dividend for 57 straight years. Where were you in 1957? That’s when this streak started. Here is what a streak like that looks like – beginning 28 years after it started.
- A decent yield. Many dividend growth investors consider yields of about 2.5% to 5% to be the “sweet spot.” That dividend return, combined with decent annual growth, is sufficient for many investors, especially when it is combined with long-term capital growth too. Here is PG’s historical dividend yield.
Notice that PG’s yield has jumped around quite a bit, while as we saw in the previous graph, its dividend has just gone up.[ad#Google Adsense 336×280-IA]The reason for the different appearance of the two graphs is that yield is a percentage (dividend divided by price), while the dividend itself I simply a dollars-and-cents amount independent of price.
The company controls the dividend, Mr. Market controls the price.
Mr. Market is fickle, so the variable price creates what appears to be a variable dividend.
But the dividend is not variable – it only goes up. Our job as investors is to make intelligent decisions: PG is a better buy when its yield is higher than when it is not.
You can see that PG’s dividend yield has not always been in the sweet spot, but that it’s currently there and has been for the past 7 years or so.
(If you want to brush up on yields, see “Dividend Growth Investing Lesson 6: Yield and Yield on Cost.”)
- Healthy annual dividend growth. Here’s the growth part of dividend growth investing.
This is extracted from the Dividend Champions, Contenders, and Challengers list available right here on Daily Trade Alert by clicking the “Dividend Growth Investing” link at the top of any page. Notice the four “DGR” columns at the right of the table. That’s where PG’s record of dividend growth is found. Look at the record:
1-yr DGR = 7.0% (that refers to 2013)
3-yr DGR = 7.9% (2011-2013)
5-yr DGR = 8.8% (2009-2013)
10-year DGR = 10.6% (2004-2013)
That is a fabulous record. DGR stands for Dividend Growth Rate. That is the compound annualized rate of growth for the time period specified. So for the past 5 years, PG has increased its dividend at a compound annual rate of 8.8% per year. (For more about the wonders of compounding, please see “Dividend Growth Investing Lesson 4: The Power of Compounding.”)
You may have noticed that the YChart shows PG’s current yield as 3.19%, while the CCC document has it at 2.99%. The reason for this discrepancy is wonderful news. The CCC chart (dated March 31) precedes PG’s most recent announcement (made on April 7) that the company will raise its dividend 7% in May. That hike (PG’s 58th in a row) caused the current yield to jump up to the 3.19% shown on the YChart. Next month’s update of the CCC will reflect the new yield, taking the hike into account.
- Solid financials. Procter & Gamble sports a Return on Equity of 16.3, a low Debt/Equity ratio of 0.3, a high gross profit margin of about 50%, and other attractive fundamentals. They have had some problems generating growth in recent years, but they are addressing the problems, and the company has a long history of solving things like that. They went through a similar softening in 2001-2002 and came out even stronger than before.
- Proven business model. PG is the world’s largest household and personal-care company. Almost 4.4 billion uses are made of PG products every day. The company has about 300 brands, with 25 blockbuster brands that generate more than $1B annually each. World-class brands include Gillette, Bounty, Charmin, Crest, Tide, Downy, Mr. Clean, Swiffer, Pampers, Iams, Olay, Nyquil, Cover Girl, Clairol, Wella, and Prilosec. The company operates in more than 180 countries, with 61% of sales coming from outside North America. The company is continually introducing new products and brand extensions, and it spends heavily on R&D and brand advertising. Given its size, PG often benefits from pricing power and leverage with retailers.
When I was scoring PG for the 2014 edition of my eBook, I gave its “Story” 11 points out of 15, which is strong. Overall, I gave PG a Company Quality score of 57, which ranked it 16th out of the 40 stocks. (Coca-Cola, for comparison, got 12 for its Story and ranked 6th overall on Company Quality.) Procter & Gamble has been a Top-40 Dividend Growth Stock every year that I have compiled my rankings. It’s an all-star.
- Low price volatility. PG has a 5-year beta of 0.44, meaning it has been less than half as volatile as the market. This makes it easier to live with during market swings, and there is research that suggests that low-beta stocks do very well in long-term total returns.
Step 2: Stock Valuation
I require more than a high-quality business to actually invest in a stock. I also require that the stock be fairly valued at the time that I purchase it. I use two simple methods to value a stock.
First, I check Morningstar’s star rating. Unlike its star ratings for funds, which generally reflect past performance, Morningstar’s ratings for stocks anticipate future performance.
In a nutshell, their analysts compute a fair value for the company based on the same kinds of factors discussed above combined with forward estimates of the company’s earnings and other financials. They go much deeper than I did in the discussion above, applying a complex mathematical model. After they have the fair value (as they see it), they compare it to the stock’s current price. Here is what Morningstar thinks of PG’s value at the moment:
The 4 stars, under Morningstar’s 5-star system, mean that they think that PG is undervalued right now. That is, they think it’s selling for less than it’s worth. We like that.
Second, I look at FASTGraphs to help me reckon value.
FASTGraphs use a different approach from Morningstar’s. (That’s why I employ both, because they come at it from different angles.) On the above chart, the orange line represents fair value as computed using a Price/Earnings ratio of 15 (as shown in the orange box to the right). That means that FASTGraphs thinks that PG is overvalued right now.
Let’s look into that quandary. Pulling up the main FASTGraph, we discover that PG is “always” overvalued. Note the blue line in the following graph, which shows the normal valuation that the market has assigned to PG:
As shown in the blue box to the right, PG’s normal P/E ratio is 19.6, not 15. It is trading slightly under that value right now.
If you average everything out, I reckon that PG’s price is fair right now. Morningstar sees it as undervalued, FASTGraphs sees it as overvalued, and simply comparing PG’s current P/E to its normal P/E suggests that it is about fairly valued. PG’s current yield of more than 3% after its recent dividend hike supports that conclusion. That’s a good yield point.
Don’t get me wrong, I would rather get a better price for PG than I got. But taking everything into account, I decided to pull the trigger and purchase shares.
This completes my first two articles about classic dividend growth companies: Coca-Cola and Procter & Gamble. It also brings you up to date on my Dividend Growth portfolio.
When I update the portfolio at the end of this month, you will see PG proudly sitting in its new position. I am very glad to own a piece of such a great American company. By purchasing when I did, when I receive my first dividend from PG in May, it will be at the new higher rate.
In forthcoming articles, I will introduce two members of my Top 40 that are not iconic companies. But I believe that they are top-shelf dividend growth companies. I will reveal their names and explain why I include them in this year’s Top 40. I am also preparing another Lesson in Dividend Growth Investing. It will be about valuation, a subject that comes up again and again when making purchase decisions, as you have just seen in my decision to buy PG.
Speaking of lessons, I urge newcomers to take a look at the Dividend Growth Investing Lessons. Each is a compact, single-topic discussion of a basic investing concept. They are easy and quick reads, and it is never a bad idea to brush up on fundamental blocking and tackling.
Dave Van Knapp
Author of Top 40 Dividend Growth Stocks