Dividend Aristocrats – those companies that have increased their dividends for 25 or more years consecutively – seem ideal for the income investor. After all, their combination of reliable and increasing income is not to be found anywhere else.

Yet, like all other investment formulae, once discovered, it becomes overpriced.

Further, the compromises necessary to achieve such a long track record of increasing dividends may in fact weaken the companies paying them – and even cause the investments to be self-defeating.

[ad#Google Adsense 336×280-IA]Thus, I suggest treating the Aristocrats with caution.

Recently, my colleagues Alan Gula and Chris Worthington both warned about Dividend Aristocrats, and I don’t want to become repetitive.

That said, I do think this group is significantly overvalued, and that we need to be careful should we choose to invest in them.

The Inherent Flaws of the Aristocracy
Before World War II, there was essentially no inflation, and companies were thought to be doing very well if they simply maintained their dividends.

AT&T (T), then including all the regional Bell companies, became known as the ultimate “widows and orphans” stock by maintaining its annual $9 dividend from the 1920s through the Great Depression until 1958. By then, inflation was eating away at the value of the steady dividend income, so AT&T increased its dividend and split the stock in 1959.

Procter and Gamble (PG), which did well through the 1950s, had figured out the persistence of inflation a few years earlier, and so began annual dividend increases in 1954. That makes it the oldest (and therefore most aristocratic) of the Dividend Aristocrats.

Other stocks followed suit in the later 1950s, but the activity wasn’t thought especially significant until after the recessions of 1973 to 1975 and 1980 to 1982, which thinned out the list of companies that had been able to maintain their increases. Then, in the 1980s and 1990s, dividend investing became unfashionable. It was only after the crash of 2008 to 2009 that the group of “Dividend Aristocrats” achieved iconic status.

In principle, a company that decides to become a Dividend Aristocrat should have an exceptionally safe dividend, since the status loss from cutting it is so great. But in practice, Aristocrat status can work the other way. Companies stretch their operations to maintain and increase their dividends, underinvesting in recessions and ultimately getting into difficulties.

Of 52 Dividend Aristocrats in 2009, 10 cut their dividends in 2010. And in the 1930s, the most likely year for Aristocrat humbling came after the trough of the recession.

Pitney Bowes Inc. (PBI), for example, had a stable business in postage meters and had increased its dividend every year since 1982. However, in 2012, its $440 million of net income was subject to $320 million of adjustments, the net of which failed to cover the $319-million cost of its $1.50 annual dividend. Therefore, with the first dividend declaration in 2013, the company halved its dividend, losing its Aristocrat status. PBI has continued to make money and pay a decent $0.75 annual dividend, but clearly hasn’t been reliable as an income stock.

As Chris pointed out a few weeks ago, a number of the current S&P 500 Dividend Aristocrats have dividend payouts ratios above 80%, putting the sustainability of their dividends in doubt (after all, we’re not in a recession). In addition, HCP, Inc. (HCP), a real estate investment trust, has paid dividends exceeding net income for the past three years. I’d regard its dividend as shaky, whatever special rules you keep for real estate companies.

The Best of the Bunch
Now, as an Englishman by birth, I like aristocrats in general (though I’m certainly not one myself). Yet after a while, you find that not all of the House of Lords are equally pleasant.

Some are vulgar nouveaux riches with flashy tastes and dodgy business ethics. Others are impossibly haughty, using their family connections to make others feel inferior. However, there are a few, like P.G. Wodehouse’s Earl of Emsworth, who have the right combination of down-at-heel friendly charm, a sense of humor, a beautiful stately home, and Plantagenet descent.

In this spirit, I give you my favorite Dividend Aristocrat: Emerson Electric (EMR).

Emerson describes itself as a “technology and engineering solutions company” and has increased its dividend every year since 1957, making it one of the most-established Aristocrats. More extraordinarily, it has had just three CEOs since 1954. The current CEO, David Farr, is only 60 and has been in office since 2000.

You hardly ever hear of Emerson in the financial press, even though it’s a $38-billion company – another good sign. With management continuity and an excellent profits and dividend record, EMR just oozes aristocracy. Its dividend yield is 3.2%, lower than usual because of the market’s exuberance, and its P/E ratio is a modest 15x.

Even if, as a good American, you disapprove of aristocracies, I think you’ll agree that EMR is one of the few exceptions.

Good investing,

Martin Hutchinson

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Source: Wall Street Daily