I Just Bought 60 Shares of This Stock

On February 12, I sold BHP Billiton (BBL), because I believe the risk of a dividend cut is very high.

I combined that money with accumulated dividends in my Dividend Growth Portfolio, and I used it to purchase Cisco (CSCO). That represents my first dividend reinvestment for 2016. I expect that there will be 3 more to come this year.

Why Cisco?

Cisco designs, manufactures, and sells networking products and services for the communications and information technology industry.

Its products include electronic switches, storage solutions, workstations, routers, video devices and software, and data center products, along with technical support services.

I will do a complete company analysis in a future Dividend Growth Stock of the Month article, but here are my most important reasons for this purchase:

1. Cisco just reached 5 years of dividend increases

Five years is my minimum (here’s why).

[ad#Google Adsense 336×280-IA]Cisco began paying a dividend in 2011, and it has increased it by a healthy amount each year since then.

If you count 2011 as the first year of an increase (going from zero to paying a dividend), then 2016 becomes Year 6 of Cisco’s young life as a dividend growth stock.

I think the company is making the transition from go-go growth company to a more mature stage in life, and that this is reflected in its dividend policy.

Capture2. Cisco’s yield is a healthy 4%+

Cisco has increased its dividend so fast that its yield has gone from zero to 4% in just 5 years. That is a high yield for a tech company. For comparison, Apple (AAPL) yields 2.2% and Microsoft (MSFT) is at 2.9%. (Disclosure: I own them both.) Many tech companies pay no dividend at all.

It is not unusual for a company to have fast dividend increases once it decides to begin paying dividends. Cisco fits that pattern.

You can see the payout jumps on the chart above. Here is Cisco’s annual record of increases.

CaptureThe company seems to have settled into a pattern of one increase per year, announced in February and payable in April.

By the way, I do not expect Cisco (or any company) to continue to increase its dividend 20% per year. But I do expect Cisco to settle into a “normal” range of dividend increases commensurate with its earnings growth, maybe in the 6%-8% range each year.

3. Cisco is a healthy company

Here are a few signs of Cisco’s quality:

• Morningstar awards it a narrow economic moat. That means that they believe that Cisco has defensible competitive advantages.
• In its earnings report on February 11, Cisco beat earnings estimates, gave confident guidance for the future, increased its dividend by 24%, and added $15 billion to its ongoing share buyback program.
• It has a relatively low debt-to-equity ratio of 0.4, and it sports an AA- credit rating from S&P.
• Cisco’s dividend safety grade from Safety Net Pro is A, meaning that they think it has an extremely safe dividend.
• Analysts estimate 9% earnings growth over the next 3-5 years. (I think that’s a little optimistic. The growth will probably be more like 6%-7% per year.)

4. Cisco was available at a good valuation

Despite the fact that Cisco’s price jumped upward after it released its earnings report, its price had been drifting downward for almost a year, making it undervalued. By my reckoning it is still undervalued. I bought it the day after the earnings report.

This FASTGraph shows CSCO as about 25% undervalued even after the price jump following its earnings report, which is the tick upward at the far right of the black price line.

CaptureImpact on my dividend income

I purchased 60 shares of Cisco. At its new dividend rate of $0.26 per share per quarter, or $1.04 per year, that works out to about $62 more per year in dividends that will be flowing into my portfolio.

That may not sound like much, but it represents about a 1.8% increase in annual dividends for this relatively small portfolio. That’s how compounding works: You make money on money already made. I had already made the money that I invested in Cisco.

In this case, I had accumulated $1000 in dividends from other stocks in the portfolio, added about $500 from closing out a position, and used the $1500 to start the new position. If things work out as I hope, Cisco will be a strong member of my portfolio for years to come, sending me more and more income each year.

As I mentioned earlier, I expect to make 4 dividend reinvestments this year. If the combined impact of them is to add a total of 5% to my annual dividend income, that means I will have generated a 5% income raise even if none of the companies increases its dividend on its own.

Of course, I expect every company to increase its dividend this year (several already have). But just focusing on the reinvestment piece perfectly illustrates the power of compounding. If you want to read more, see Dividend Growth Investing, Lesson 5: The Power of Reinvesting Dividends.

When I update my Dividend Growth Portfolio at the end of the month, it will reflect the removal of BHP Billiton, the addition of Cisco, and new estimates for the income expected in 2016.

— Dave Van Knapp