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Rising interest rates affect all businesses, not just dividend paying ones
Posted by: Dividend Growth Investor (IP Logged)
Date: June 25, 2013 08:16AM

Ever since the “correction” in dividend paying stocks began five weeks ago, I keep learning that the so-called dividend craze is over. The argument goes that dividend paying stocks are less attractive for investors today, because rising interest rates will make them less appealing.

Before I address this argument on rising interest rates affecting the appeal of dividend paying stocks, I am going to quote Charlie Munger, who has been Warren Buffett’s business partner for half a century.

“I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”

Unfortunately, I find that people arguing against dividend investing never get their facts straight, and usually resort to manipulating their examples in order to prove their point. Whether this is based on reality or not, is not important for them.

Over the past 3 months, the yield on the benchmark 10 year US treasuries has increased by 50%. While the term 50% seems like a lot, in reality it is used to describe the fact that yields increased from a low of 1.60% in April to a high of 2.50% in June. To put it in perspective, if you were a retiree with $1 million in cash, who purchased ten year treasuries in April 2013, you would be entitled to receive $16,000 in annual interest income for ten years. If you had waited to invest the money today, you would be entitled to receive a little over $25,000 in annual interest income for ten years. In other words, you went from a situation where your money is not earning too much, to a situation where your money is still not earning enough.

The worst part is that investors in US treasuries are still not earning enough to compensate them for inflation, taxes and to earn a decent livable return. At the end of their maturities in 2023, investors would get their $100 back, but it would likely have the purchasing power of about $74 today, assuming a 3% inflation rate per year. If our enterprising investor instead decides to purchase dividend paying stocks, they would be able to generate distributions which grow at or above the rate of inflation, can also protect principal from inflation, while enjoying a preferential tax treatment. As a result, a a portfolio of dividend growth stocks yielding 2.50% today which grows dividends at 10%/year will generate $25,000 in income today based on a $1,000,000 portfolio. In seven years however, this dividend portfolio will generate an annual dividend stream of $50,000.

As you can see, investors who argue that rising interest rates are bad for dividend growth stocks forget that they are not bonds, and therefore can increase dividend checks to compensate for holding the security. Of course, selecting a quality dividend stock does take some effort, which requires screening, analysis of underlying business prospects and purchasing the security at attractive valuations.

In reality, I think that rising interest rates are really bad for fixed income securities such as treasuries and preferred stocks. The fixed coupons provide an illusory safety that income cannot be cut or eliminated. In reality, the purchasing power of these coupons is decreasing every single year. Dividend stocks are not bonds however, as the underlying business behind the security provides a built in inflation protection in aggregate.

When I invest however, I view shares of dividend paying companies as partial ownership stakes in businesses. I try to invest in those quality companies which I would be happy to hold through several cycles of rising and falling interest rates, economic expansions and recessions and stock market volatility. My holding period is essentially forever. This could range from 20 years all the way to over 50 years ( if I am particularly lucky). As a result, any data point less than one year is viewed as noise in my book.

I have outlined below a few dividend growth stocks which are attractively valued, and have exciting prospects ahead:

McDonald’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. This dividend champion has managed to boost distributions for 36 years in a row, and has a five year dividend growth rate of 13.90%/year. Currently, the stock is trading at 18 times earnings, yields 3.10% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of McDonald’s.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has managed to boost dividends for 5 years in a row, and has a five year dividend growth rate of 13.10%/year. Currently, the stock is trading at 16.80 times earnings, yields 3.90% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of PMI.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. This dividend champion has managed to boost distribution payments for 26 years in a row, and has a ten year dividend growth rate of 9.20%/year. Currently, the stock is trading at 9 times earnings, yields 3.30% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of Chevron.

Aflac Incorporated (AFL) provides supplemental health and life insurance products in Japan and US. The company has managed to boost dividends for 30 years in a row, and has a ten year dividend growth rate of 10.90%/year. Currently, the stock is trading at 9 times earnings, yields 2.50% and has an adequately covered dividend. Earnings per share are projected to increase by % over the next five years. Check my analysis of Aflac

To be perfectly clear however, rising yields on treasuries do signal that cost of capital will be higher over time. This does affect corporate profits, as many companies borrow extensively to finance their daily operating needs. The sad part that many anti-dividend arguments miss is that rising interest rates are not good for businesses in general, not just dividend paying ones. However, because the economy is doing better, companies will be able to sell more goods and services, which would offset rising interest rates. However, companies with strong competitive advantages will be able to generate rising profits over time. They can deal with the cost of higher interest rates by passing higher costs to customers who want the products, making operations more efficient by reducing duplicate functions, or working ways to reduce the need for borrowing to finance short-term operations.

Full Disclosure: Long MCD, PM, CVX, AFL


Stocks Discussed: MCD, PM, CVX, AFL,
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