On January 25, Barron’s published an article called “Get Lucky: IQT’s Lucky 13 Portfolio.” In it, the publisher talked about the reasoning behind why 13 dividend-paying stocks were highlighted in the article. Let’s walk through the reasoning behind these 13 stocks and how the assessment of some of these dividend picks applies the Valuentum Dividend Cushion framework (click here), in part or in whole. Valuentum’s Brian Nelson also gives his quick thoughts on the comments of each company as if he were training a new analyst on how to interpret the article from an analytical standpoint.
Abbott Labs (ABT): “a solid anchor position for any portfolio…Free operating cash flow is three times its dividend.” Nelson’s thoughts: Abbott is clearly a solid firm, and we point to the idea that the article’s assessment of Abbott is based on free operating cash flow relative to dividend payments, a large portion of the construct of the Valuentum Dividend Cushion. The first component of the Valuentum Dividend Cushion—assessing future cash flows relative to future dividend payments—is about as relevant as it gets with respect to dividend growth analysis. Abbott’s Valuentum Dividend Cushion score is 2.2 at the time of this writing (see ). We’re watching the firm closely.
Baxter Intl (BAX): “another defensive anchor position. The global medical-products and services company boasts outstanding dividend growth. Its return on equity for the trailing 12 months and five-year average are 29.31% and 30.42%, respectively.” Nelson’s thoughts: We like Baxter’s dividend growth prospects—its Valuentum Dividend Cushion score is 1.8 (see ) at the time of this writing. Still, the mentioning of return on equity in this article brings up a very important topic. The most important measure of a company’s ability to generate value for shareholders is return on invested capital (ROIC), not return on equity (ROE). Breaking down the return on equity equation into the DuPont formula (see here) shows why. The equity multiplier (assets/equity) or leverage—the third component of ROE in the DuPont formula—can be manipulated by management’s financing decisions. Though Baxter is clearly not suspect (the company’s ROE is very similar to its ROIC), in other cases, for example, a management team can throw a lot of debt on an otherwise poor business to generate high return-on-equity marks. We think you should be aware of the risks you take by employing any portfolio manager and/or financial advisor that uses return on equity as a core component of their stock-selection process. Return on invested capital is the best measure, and the one we use at Valuentum.
Chevron (CVX): “a $4-per-share dividend…and an S&P A+ quality ranking. [And it’s] a Dividend Aristocrat, to boot. A must position for a quality portfolio.” Nelson’s thoughts: Many know that S&P is best-known for its credit ratings. The highlighting of Chevron’s solid debt rating is an indication of the importance of the health of the balance sheet in dividend growth analysis—the second core component of the Valuentum Dividend Cushion. Specifically, within the construct of the Valuentum Dividend Cushion, a company’s cash position on the balance sheet is netted against its debt position, as excess net cash can be used, if need be, for future dividend payments. Though we note that Chevron’s balance sheet is starting to lose its luster (see here), the company remains a holding in the Valuentum Dividend Growth portfolio. Chevron’s Valuentum Dividend Cushion score is 1.9 (see ) at the time of this writing.
Coca-Cola (KO): “in a world gone mad, what could be more sane than buying one of the world’s best-known trademarks that has grown profits in 76 of the past 80 years, is a Dividend Aristocrat, [and] has a return on equity of over 30%.” Nelson’s thoughts: We like Coca-Cola as a divided growth idea and peg the firm’s Valuentum Dividend Cushion score at 1.8 at the time of this writing (see ). We prefer Coca-Cola over rival PepsiCo, and we’ll explain why a bit later in this piece. Please also note the mentioning of ROE. Coca-Cola’s return on invested capital is very healthy, but the latter should always be evaluated (or at least used in conjunction with the former).
ConocoPhillips (COP): “is well on its way to challenging the giants in the oil and gas industry…It’s in the second phase of its multiyear makeover and has disposed of over $12 billion in unwanted assets…The company is now focused on growth.” Nelson’s thoughts: ConocoPhillips may be operating better than its major peers, but we remain cognizant of the volatility of its end markets and the investing phase the firm currently resides. The firm’s uses of cash may be better suited for other endeavors, which begs the question of just how strong future dividend growth will be. ConocoPhillips’ poor Valuentum Dividend Cushion score of 0.5 (see ) speaks to a company that is starting to stretch its balance sheet as it rapidly invests for both top-line and dividend growth. We no longer hold ConocoPhillips in the portfolio of the Dividend Growth Newsletter, solely on the basis that we think there are healthier alternatives.
CVS Caremark (CVS): “has free operating cash flow of three times its dividend, and ‘just produces year in and year out.’” Nelson’s thoughts: Again, we have an instance where a core component of the Valuentum Dividend Cushion methodology is being applied in a dividend growth assessment, albeit perhaps indirectly—comparing free operating cash flow to cash dividend payments. CVS’ Valuentum Dividend Cushion score is 2.1 at the time of this writing (see ), suggesting a healthy dividend payout. However, the firm’s annual yield is sub-2%, and we think income investors can do better than this without taking on more risk.
ExxonMobil (XOM): “is the oil and gas giant and a Dividend Aristocrat.” Nelson’s thoughts: You’re not going to find us differing too much with a positive assessment of this energy giant. The company’s Valuentum Dividend Cushion score is a healthy 1.9 (see ), indicating strong potential for future dividend expansion. It is yielding nearly 3% at the time of this writing, and if it weren’t for Chevron’s materially higher annual yield, ExxonMobil would probably have a home in the Dividend Growth portfolio.
McDonald’s (MCD): “the No. 1 fast-food restaurant company in the world, is an icon. Dividends and the stock price have been in a major uptrend for 10 years.” Nelson’s thoughts: We have a relatively unique view on McDonald’s. We think its best menu/product innovation is behind the firm, and slowing dividend growth in coming years should be expected. The mentioning of the company’s historical track record is great, but history is only as important as it informs the future. Said differently, a strong and consistent past is nothing if a company’s future is bleak. McDonald’s Valuentum Dividend Cushion score is 1.1, not nearly as strong as some of the others’ on this list (see ). Though McDonald’s remains a formidable company, we simply think there are much healthier dividend-growth alternatives out there than McDonald’s, especially for long-term investors.
Occidental Petroleum (OXY): “is making itself over into a smaller, more efficient company with more exposure to U.S. shale assets than to higher-risk overseas ones. Proceeds from sales abroad are being used to buy additional domestic assets and for stock repurchases.” Nelson’s thoughts: Occidental Petroleum recently upped its dividend (see here), and the firm’s Valuentum Dividend Cushion score is among the best on this list (updated dividend report is pending). We’re taking a very close look at including the firm in the Dividend Growth portfolio, and you shouldn’t be surprised if Occidental is part of the portfolio in coming months.
PepsiCo (PEP): “is a nice complement to Coke in the defensive sector and is more diversified.” Nelson’s thoughts: Though PepsiCo’s Valuentum Dividend Cushion indicates that the firm’s cash-flow generation and balance-sheet health are sufficient to satisfy a growing dividend, Coca-Cola is clearly the better alternative, in our view. Our team put together the following assessment recently (source), per third-quarter 2013 results:
It’s clear to us the stronger cash-generator between Coca-Cola and Pepsi is the former, on the basis of free cash flow relative to revenue. Coca-Cola’s $17.3 billion in cash on its balance sheet compares to $14.2 billion in long-term debt, while Pepsi’s $9.6 billion in cash compares to more than $24 billion in long-term debt obligations. This significant difference in financial health is apparent in Coca-Cola’s better Valuentum Dividend Cushion score.
Philip Morris Intl (PM): “because the tobacco business, although controversial, ‘is basically unaffected by economic slowdowns or rising commodity prices, which means it is stable and defensive.’ Nelson’s thoughts: Though we agree that Philip Morris’ international growth opportunities may be better than Altria’s (MO) core business, the latter has an ace up its sleeve in the form of its ownership stake in SABMiller. Altria can monetize this stake over time to the complete benefit of existing shareholders, issue a massive one-time dividend payment from sale proceeds of SABMiller, or continue to reap the benefits of SABMiller’s emerging-market expansion by retaining its existing stake. Altria remains a holding in the actively-managed portfolios.
Reliance Steel & Aluminum (RS): “is North America’s largest metals service company and is looking to get even bigger. It has enriched dividends 20 times since its 1994 public debut.” Nelson’s thoughts: You won’t see us venturing too far into the commodity-producing space for dividend growth opportunities. The steel and aluminum markets are exposed to not only volatile input costs, but also violent pricing cycles. This is not an idea that we think will reward long-term holders, despite its impressive track record.
Union Pacific (UNP): “Given the nation’s limited pipelines, crude oil and petroleum derivatives have to get to refineries and ports somehow, (Union Pacific), with almost 32,000 rail miles linking both coasts and the Midwest with the Gulf ports, is just the ticket.” Nelson’s thoughts: Union Pacific is our favorite railroad idea. The company was recently added to the Best Ideas portfolio (see transaction archives here), and the firm recently upped its dividend payment (see here). We like the company quite a bit.
Valuentum’s Take
The Valuentum Dividend Cushion is widely-used or applied, in part or in full, even if it is not mentioned by name. We believe the measure is one of the most powerful, systematically-applied tools available to individual investors today. Many dividend growth investors periodically monitor the Valuentum Dividend Cushion scores of their portfolio constituents, as either changes in the future estimates of free cash flow, impending large capital structure shifts, and/or a reassessment of the trajectory of dividend growth can all impact the measure. Generally speaking, a Valuentum Dividend Cushion score above 1.25 is considered healthy by our team.