A company that generates so much excess cash flows that it can not reasonably reinvest all of it into the business has possibly a high return on equity. Such a business needs only a portion of profits to be reinvested back to maintain and grow operations, leaving excess cashflows filling in the company treasury coffers. This growing pile of excess cashflows, allows companies to pay a rising dividend stream of decades to come.
Such a company probably has a product or service, which is unique, and provides value to customers. These products are typically characterized by strong brands, that carry a premium and consumers are willing to pay top dollar for. The competitive advantages of the company would likely be difficult to replicate because of patent protection, trademarks and know-how, customer relationships, difficulty to switch providers, scale that could be very expensive to replicate to name a few obstacles. This is what Buffett refers to as a company that has a wide-moat.
A long streak of dividend increases is not a slam dunk of course, as things can change over time. However, if you determine that the business has higher odds of continuing their profitability streak, and you can buy it at attractive prices, then it might be a good holding for the next several decades.
These companies could spend a lot of shareholders’ money on research, acquiring other companies or doing something else to try and earn even more. However, placing all excess profits back into the business alters the risk profile negatively. This is because you are moving from earning money from a relatively lower risk rate of profits that you earn in ordinary course of business, to taking somewhat of an educated gamble with shareholders money. If a company has a worth of $1 billion, and wants to acquire another firm for $100 million, it does not need to use reinvested profits. It might be better off to either take on debt or issue equity, particularly if its shares are overvalued. However, many times acquisitions do not work and are utter failures.
For example, in 2012 Microsoft (MSFT) wrote off its entire $6.20 billion purchase cost of digital ad company aQuantive. Some do work of course, and can lead to synergies and all the other buzz words meaning cost savings. However, it is difficult to have different cultures merged together, and it is also difficult to acquire companies that are from different industries. For example, during the 1960’s, the term “leisure” was a catchphrase, which demanded high P/E multiples. People were all supposed to work less because of advancements in technology, and therefore have more leisure. According to Michael O’Higgins in “Beating the Dow”: “a company that made surfboards and sold books somehow had synergy because they were leisure-related”.
As far as investing in R&D goes, or opening new locations, the return on investment is not guaranteed. If a tobacco company tries to create cigarettes with low nicotine levels, it might do so, but the new product could create negative associations to consumers. If Pfizer (PFE) spent $5 billion developing new drugs, there is no guarantee that the funds would result in new discoveries. In retail, if a company like Wal-Mart (WMT) doubles the number of stores overnight, this will not result in doubling of sales. This is because you need to take into effect cannibalization of sales from existing stores, legal restrictions from opening a store in certain locations, specifics of local markets as well as time it takes to research market and build a store.
For example, Coca-Cola (KO) could not reinvest all of its profits in the business, because for many decades it had multiple limitations. Prior to 1989’s fall of the Berlin Wall, it could not easily expand into the countries from the Soviet Bloc or in their ally countries. In addition, Coke products are not cheap for many people in countries like China, India, Russia and other developing countries. As more people in emerging markets become middle class, Coca-Cola would be able to deliver its product to them, using a network of bottlers. However, this would take time.
This could also mean that once companies reach a certain scale, profits are then returned to shareholders to do as they please. As an investor who plans to live off my nest egg, I highly prize companies that can shower me with cash on a regular basis. This is because dividend income is more stable than relying on stock prices alone. I value the stability and relative certainty in the amount and timing of dividend income, because it makes it easy to plan and budget my expenses. I do not want to worry whether I can afford one or two PBJ sandwiches if markets drop 50% tomorrow.
Many readers complain that I keep writing about the same stocks over and over again. The hidden truth is that there are only so many businesses in the US which are exceptional and publicly traded.
Johnson & Johnson (JNJ), together with its subsidiaries, engages in the research and development, manufacture, and sale of various products in the health care field worldwide. This dividend aristocrat has managed to raise distributions for 51 years in a row. Over the past decade, it has managed to reward shareholders with 11.70% in annual dividend raises on average. Currently, the stock trades at 16.50 times forward earnings, and yields 3%. Check my analysis of Johnson & Johnson.
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 aristocrat has managed to raise distributions for 36 years in a row. Over the past decade, it has managed to reward shareholders with 28.40% in annual dividend raises on average. Currently, the stock trades at 17.40 times earnings, and yields 3.20%. Check my analysis of McDonald’s.
Exxon Mobil Corporation (XOM) engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products. This dividend aristocrat has managed to raise distributions for 31 years in a row. Over the past decade, it has managed to reward shareholders with 9% in annual dividend raises on average. Currently, the stock trades at 11 times earnings, and yields 2.90%. Check my analysis of Exxon Mobil.
Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company operates in three segments: Walmart U.S., Walmart International, and Sam's Club. This dividend aristocrat has managed to raise distributions for 39 years in a row. Over the past decade, it has managed to reward shareholders with 18.10% in annual dividend raises on average. Currently, the stock trades at 14.60 times earnings, and yields 2.50%. Check my analysis of Wal-Mart.
The Coca-Cola Company (KO), a beverage company, engages in the manufacture, marketing, and sale of nonalcoholic beverages worldwide. This dividend aristocrat has managed to raise distributions for 51 years in a row. Over the past decade, it has managed to reward shareholders with 9.80% in annual dividend raises on average. Currently, the stock is slightly overpriced at 20.50 times earnings, and yields 2.90%. Check my analysis of Coca-Cola.
Full Disclosure: Long KO, WMT, MCD, JNJ
- High Yield Dividend Stocks in Gurus' Portfolio
- Top dividend stocks of Warren Buffett
- Top dividend stocks of George Soros